"Bears make money. Bulls make money. Pigs get slaughtered." - Wall Street proverb
Markets can defy gravity for a long time. The current bull market has been going strong for nearly a decade. The result has been an elevation of equity prices across the board, with the stock market at its highest point in history and individual stocks trading at historically unheard of price-earnings ratios.
The ebullience was dimmed somewhat during this month’s short-lived correction, which saw all the gains of 2018 erased overnight. There were a couple ugly days of trading, but fears of inflation and rising interest rates were ultimately leavened with better-than-expected economic data. The result has been a return to normalcy, or close to it at least. Yet, while the market has largely shaken off its jitters, the fear on display during the mini-correction may prove to be a foretaste of things ahead.
A serious market correction could end up doing a favor to one class of investor that has suffered throughout the interminable growth spurt of the past decade: value investors.
Corrections are inevitable
The stock market always corrects itself eventually, with variable degrees of speed and severity. Given the long and sustained bull run we have been enjoying, which has seen virtually unprecedented asset price inflation, a correction looks ever more justified. Asset prices usually rise faster than the value of the real economy during a bull market, but the total disconnect that has transpired in recent years is quite shocking. The market seems to think the good times will never stop. It is worth pausing to remember investors throughout history, despite witnessing and experiencing market corrections, and even full-blown bear markets, have managed to convince themselves “this time will be different.” Foresighted investors will do well to remember it is never different.
Looking for the trigger
When asset prices fly far beyond economic fundamentals, something inevitably pushes them back toward reality. What is different every time (or most times) is the trigger. What will set off the next correction is not easy to say. But the recent panicky behavior over relatively minor inflation and interest rate issues shows investor sentiment is rather brittle and, thus, susceptible to a real shock. What that shock will be remains to be seen, but it may not take much to send the market into correction mode.
Ever seen a bear market?
The current bull market has gone on so long many traders and investors have little experience of what a bear market is like. Obviously, the senior executives at investment banks, hedge funds, PE outfits, etc. remember the 2008 crash and recession; most of them will have had intimate experience with the dot-com bubble and the big bear of previous decades. But for the folks in the trenches and in mid-level coordination roles, those bear markets are simply history, or something that happened early in their careers. These individuals, when taken as a group, are less well prepared and psychologically equipped to deal with a downturn than perhaps any cohort of investment professionals. Their adverse reactions, or inability to adapt, could have profound consequences for rational adaptation to market actions during a downturn, and even drag on the eventual recovery.
Value strategies strike back
This is where value investors come in. With prices stratospherically high across the board, finding cheap stocks worth buying has been awfully difficult in recent years. Some of the biggest names in the value investing world have despaired at finding bargains. A correction could be just what the doctor ordered for this type of investment strategy. It will put good stocks into a more justifiable buy range as well as potentially put financial pressure on leveraged companies, presenting further opportunities to invest in temporarily distressed or cyclical businesses.
Outlook
As a student of economics, finance and history, I know a correction will come. But I do not have a crystal ball and, thus, cannot say when or how that correction will come. Investors should get ready for choppier waters ahead, and for the potential for a nasty correction. Modifying portfolio allocations and thinking about how one’s investments will perform in the event of a downturn is more important than ever. A defensive posture is definitely warranted in these uncertain times.
Disclosure: I/We own no stocks discussed in this article.
