2019 Lane Reports

Learning to Love Corrections

The Lane Report, March 2019
Friday, March 1, 2019 7:00 am
by Kenneth N. Green

Learning to Love Corrections
By Kenneth N. Green, MBA, CPA

Last year, between September 28 and December 24, the S&P 500 dropped from 2,914 to 2,351, or 19.3%, with most of that occurring in December alone. Such market corrections are like summer storms in that they seemingly come from nowhere and are very scary. Between February, 2016 and January, 2018 the S&P 500 did not have as much as a 5% correction. Hence, investors became complacent. Although precise data is scarce, it appears that the December sell-off was prompted by massive institutional liquidations, most likely by hedge funds looking to clear their books and generate cash for disappointed investors who may redeem only at designated times. Most hedge funds were incorrectly bullish for 2018.

Unfortunately, many individual investors sought the shelter of cash and missed out on the upside that 2019 has brought so far. As of this writing, the S&P 500 is up 10.7% this year and fully 18% since the Christmas Eve low. Just as bull markets do not ring a bell at the top, so it is that corrections do not ring a bell at the bottom. If the businesses that you own are solid and have rising revenues, earnings, and dividends and their valuations are fair, then corrections should be viewed as buying opportunities and not times to sell. Many years ago, Peter Lynch wrote, “What makes stocks valuable in the long run isn’t the market. It’s the profitability of the shares in the companies you own. Corporations become more valuable and sooner or later their shares will sell for a higher price.” And Charles Munger, Vice Chairman, Berkshire Hathaway wrote “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw irrational emotion under control.” Just as bull markets breed complacency, corrections and bear markets lead to irrational selling. Too often people react to stock price movements without analyzing the profitability of the companies they own. There are indeed good reasons to sell stocks that you hold such as overvaluation and poor profit outlooks. But a falling stock price alone is not a good reason to sell.

When stocks fall fast, going to cash can make one feel - - and sleep - - better. However, it also can lead to missed opportunities when stocks recover. S&P 500 price returns in the twelve months following all corrections since 1925 average 34%. Timing your exit from the market requires not one, but two decisions, the other being when to re-enter. Sadly, for many this means selling at a low point and buying again “when things look better,” that is, when the market is higher. This is a recipe for wealth destruction. As upsetting as volatility can be, it leads to more attractive asset prices that better reflect fundamentals and future prospects. The last thing anyone should want is a repeat of the 1999-2000 dotcom-era bubble when asset prices were more than two standard deviations above trend line. We needn’t rehash the aftermath of that debacle.

The good news is that you don’t need to time markets to achieve long-term growth in stock prices. The S&P 500’s long-term average annualized return of 9.9% includes thirteen bear markets and several dozen corrections. Trying to market-time corrections only increases risk because it leads to missed upside and lower long-term returns.

So where does this leave us for the remainder of 2019? Beginning – year predictions of year-end price points for the major market indices rarely turn out to be accurate. Most of these are subject to herd instinct. Economies and markets are not the same: one may lead the other, or not, at different times. U.S. and overseas economic growth still looks good, although not quite as robust as it did just months ago. U.S. employers added 312,000 jobs in December and the Labor Department revised upward the previous two months by 58,000. The unemployment rate went up from 3.7% to 3.9%, reflecting nearly 420,000 people re-entering the labor force, so this too counts as good news! Since the Fed’s price and employment objectives have been met, investors should expect one or maybe two rate hikes in 2019. This will likely result in continued market volatility is the price we pay for long-term performance. Portfolios comprised of high quality securities, including equities with growing dividend payouts and solid balance sheets, have the best potential to limit downside risk while still participating in upside market action.

1. Source: FactSet, as of 12/7/18. S&P 500 price returns twelve months after correction troughs, 5/14/1928 – 2/11/2017.
2. Source: Global Financial Data, Inc., as of 1/9/2019. S&P 500 Total Return Index, 12/31/1925 – 12/31/2018.

Kenneth N. Green is Senior Vice President and Director of Investment Research for Marc J. Lane & Company. Mr. Green is a graduate of the University of Michigan (M.B.A.) and the University of Illinois at Urbana (B.S.). Mr. Green is also a Certified Public Accountant (CPA).

 


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