August 20, 2013

Of corrections, retractions and pullbacks

The US market pulled back recently after a succession of all-time highs. What does this mean?

Let’s put it in perspective: The market’s biggest setbacks are generally associated with recessions or major fundamental shrinkages of economic growth. These market downturns have averaged almost 27% since World War II. But smaller market setbacks, or corrections, occur with great frequency over time. After all, with a nod to Ben Graham and Warren Buffett, the market is a device that is a cross between a weighing device and a voting machine, constantly changing, moving up and moving down. The market’s fluctuations are the sum of the current actions and moods of the active players buying and selling on any particular day. It is not a stable system.

The market action in August 2013 is upsetting but does not yet qualify as a correction. This downturn comes upon a market that has had a prolonged, steady upward move of a large magnitude in historical terms –– rising 27% since July 1, 2012. This slight downturn follows a brief drifting-down period, and thus far does not even qualify as a correction.

Let’s review some terminology: A bear market is a prolonged market downturn of 20% or more from a previous peak. Bear markets often last nearly a year. A correction is less severe and not as long-lasting. It is usually defined as a 10% fall in index prices from recent peaks and typically lasts around 90 trading days (John Prestbo, Dow Jones).

What should we expect now and when should we get back in? The first thing investors need to ask themselves is whether the current climate is the sign of a coming recession. In that case, the market would likely drop further and the downturn could last a year or more. If that is happening, then the answer would be "stay out!"

This is important because the market often begins to peak six months before a recession. But this hardly looks like a recession in the making. Recessions since World War II don’t look quite like what we are seeing now. Usually, recessionary market slumps are preceded by a prolonged drop in corporate profit margins. This has not happened yet. Also, the majority of recessions since WWII have been accompanied by or caused by central bank tightening. No one now believes that the US Federal Reserve will tighten soon, even though the Fed’s idea is to be less easy with money, likely beginning in September. Further, economic recessions often involve the deflation of a capital binge or credit boom, neither of which seems to be happening now.

So, if no recession is in the offing, when do investors go back in? Let’s look at history and fundamentals. History says that corrections can last for around 90 trading days, or a quarter or more. So, there is no rush now to get back in.

As for fundamentals, one needs to match them with valuations. Valuations have recently moved ahead of fundamentals, as revenues in the S&P 500 Stock Index have flattened out and the market has looked the other way. Year-over-year profit growth has slowed, and yet this year stock prices are up 18%. Maybe the market has just gotten ahead of itself.

Be patient and hold to the idea that fundamentals win out over the long run. This market downturn will bring valuations back in line. These price declines may be a necessary adjustment period to an uncertain future for interest rates and dubious growth rates abroad.

I see this as an opportunity to add, but not now. Investors can wait and see how Q3 earnings turn out. If this business cycle is longer than normal, then more good news is coming — but not yet.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.


1 comment:

Joseph P. Lindsley Sr. said...

Jim, first, thank you for this blog. Secondly, I for one have been waiting for a reasonable pull back so that I can feel more comfortable with allocation strategies going forward. Although I can visualize economic improvement and the resulting investment opportunities, I remain convinced that the inappropriate levels of government interference have caused and will continue to cause delay and uncertainty to that outcome.

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