Corrections in the stock market

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On average, we have a correction of around ten percent every year in the stock market. The record in terms of the number of corrections is for the year 2008. Then there were no less than seven, in 1974 five and last year still four. Usually, there is only one, although there are years in a row when there is no correction of any significance. The corrections are the price that every investor has to pay for the high returns on shares. There are people who claim that they can anticipate these corrections. In the past, there was even an asset manager who stated that if things went badly, they would no longer be in the market. In the end, the returns of this asset manager lagged so far behind the market that they gave up.

Two types of corrections

There are two types of corrections: bull-market corrections and bear-market corrections. A bull-market correction is a correction of typically ten percent or so. Fundamentally, usually little has changed, but the market is a bit ahead of the music. It is even possible that there is a euphoric mood in the stock market. The risk is then great that the prices rise more than is fundamentally justified. Time to let off some steam. Now, it is very difficult to predict exactly when such a correction will start. Euphoria cannot be measured as easily as fear. The advantage of fear is that it is very contagious and once everyone has been infected with it, we are at the bottom. Euphoria is much more of gradual development, and a euphoric mood can last much longer than a period of extreme fear. A period of extreme fear is usually followed by a sharp price recovery. This is annoying for those who try to predict the market because very bad days are therefore often clustered around very good days. With each fall in price, there are again prophets who predict the end of times, only to be humiliated by the market a week later. A period of euphoria need not be followed by a sharp correction. If the fundamentals remain good, there is often a correction in time. Prices then stand still and sometimes move sideways for a long time. In that case, it is of no use whatsoever to predict when the correction will begin and when it will end. But even if there is a ten percent correction, it is unwise to try to anticipate it. After all, the investor has to get it right twice, once out and then back in again. It is very unusual for someone to be able to predict both the top and the bottom exactly. As a result, a maximum of 5 to 7 percent of the ten percent is usually leftover. The investor then incurs two costs and has to hope that part of the further upward phase is not missed. After all, the fundamentals have not changed.

Bear-market correction

A bear market correction is another animal. Then there is a correction of twenty percent or more. The reason is usually that something has fundamentally changed. In the past, for example, this was because the price of oil doubled within a year. Today, the importance of oil for the economy is much smaller than, for example, in the 1970s. The bursting of a bubble can also cause a bear market. A classic example is the dot-com bubble in the year 2000, although the double bubble in Japan in 1989 was slightly larger. In both cases, monetary policy played a major role. In the case of Japan, interest rates were too low due to the adjustment of exchange rates after the Plaza Agreement in 1985. This low interest rate caused a lot of speculation, both in the stock market and in the property market. In the dot-com bubble, central banks were on hand to counteract the negative effects of Y2K. The result was that money was free, and then it was easy to blow bubbles. A bear market can also be caused by the central bank raising interest rates. In the past, this was more likely than now. The last time was in 1982 when Paul Volcker, by raising interest rates, caused a double-dip recession and a strong bear market. At the same time, this was also the start of a long-term bull market in the 1980s and 1990s. The likelihood that central bankers will cause such a bear market again is less great. There is now so much debt in the world that such a deliberately induced correction will cause financial instability, the moment when the debt-deflation spiral causes central bankers to lose control. Bear markets on average last much longer than a ten percent bull market correction. Predicting a bear market is not easy either, although afterward everyone has a clue. At the same time, in a bear market the fundamentals are affected, things like liquidity, economic growth, or valuation. These factors form a solid basis for a view of the stock market.

Sense and nonsense of timing

The reality is that more money is lost in predicting a correction than in the correction itself. Many people who should be investing never do so or do so far too late, the reason being that the stock market is now too high. Investors also have great difficulty staying put in turbulent times. At any given moment, prices fall more than they had anticipated, and such a risk requires psychological action. That action, at the moment when the normally long investment horizon is exchanged for a horizon of less than a week, usually means the decision to sell everything. That is the moment when an investor faces the real risk of investing, and that is the permanent loss of wealth. Investors would do well not to look at the prices too much in the meantime. Prices are only important at the moment you want to sell and most investors do not want to do that, because they have a long investment horizon. Moreover, when you want to buy, prices cannot be low enough. Everyone is euphoric when shops have a sale, but the opposite is true when there is a sale on the stock exchange. Emotion plays an important role in these developments. Incidentally, this is by no means limited to private investors. Institutional investors run an increased career risk at times like these. A classic example is the announcement made by institutional investors at the bottom of 2003 that they had protected themselves against further price falls by going massively short on futures. That moment coincided exactly with the lowest point in the stock market. It is of all times. Last year, several institutional investors announced that they had completely abandoned the commodities category. That was at or near the bottom in the commodities market. Every investor is human and should be aware of these emotions. Decide in advance what is rationally sensible in such a situation and act accordingly.

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