The Next Market Correction Cannot Be Predicted, But You Can Be Prepared

No one can be sure when the next market correction will occur, but it will likely hurt speculative investments the most, so you can safeguard your portfolio

A market correction is a downward movement in the stock market, usually more than 10%. Market corrections can also take place in commodity or bonds markets.

Investors often ask about our predictions for the next market correction. The trouble is that corrections—temporary setbacks in stock prices—don’t follow any predictable schedule or cycle. Depending on what you look at, you can almost always make a case that we’re due for one. More often than not, you’ll be wrong. There are too many different factors that can touch off a correction, or stop one from happening.

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Will the next market correction prediction focus on the market rising too far, too fast?

Many correction predictions start with the idea that the market has gone up “too far, too fast,” as the saying goes. This, though, depends on what time period you look at.

For example, if you measure the lows between 2003 and 2017, the market was up a little under 200%. However, that’s only about 8%, compounded annually over 14 years. It’s about average performance for the market, judging by studies going back to the mid-1920s.

If you’re sure the market is due for a good setback, you need to take a skeptical view of what you can gain or lose by acting on that supposition. After all, “due for” could mean the correction will begin today. Or, the next correction could go from “due” to “overdue.” It may only appear many months or years from now.

On occasion, investors decide the market is due for a correction, and profit by acting on that decision. They may sell just before the correction begins, and buy back right around the time when the correction ends and prices resume their rise. Or they may hold off on new buying until the correction is well underway, and then buy at lower prices. More often, however, investors wind up worse off by acting on predictions of a correction. The gains they miss out on overwhelm any losses they avoid.

The market never gets so high that it can’t go higher

It’s true that the market periodically rises to exaggerated, outrageous, even silly heights. But any connection or similarity between or among any two (or more) of these peaks is trivial, subjective or both. You can spot these heights in hindsight only.

Many advisors have come up with rules that aim to help you decide if a correction is imminent. They aim to help you spot a time when you can sell some or all of your stocks, prior to a drop that’s deep enough that you’ll be able to buy them back at a lower total cost. When any of these rules “work”, however, it’s a coincidence. None work consistently.

The classic way to judge whether the market is cheap or expensive is to compare returns available from stocks, on the one hand, and the interest rates on bonds, on the other. When stocks give you higher yields than bonds, we see little point in buying bonds or other fixed-return investments in most portfolios.

Market corrections are hard on low-quality or speculative stocks

A speculative stock is a higher-risk, more aggressive stock with uncertain prospects. Speculative stocks may offer significant returns to investors—but they will also have risk to match. The odds are against you when you invest in speculative stocks and companies that are not yet making money. Some if not many of these companies will never make any money.

When a market correction comes, it’s likely to be particularly hard on low-quality or speculative investments. That’s because during those times many well-established stocks are downright cheap in relation to their earnings and the dividends, compared to bonds and other fixed return investments. In contrast, many speculative stocks may appear expensive at current prices, in view of the financial performance you can reasonably expect for them.

In a stock market correction, investors tend to sell low-quality stuff and move their money into higher-quality investments. Either way, it is always a good time to reduce or eliminate your most speculative exposure. We don’t advise you to sell anything out of a portfolio of well-established companies because we believe a balanced portfolio of high-quality stocks will produce above-average gains over time.

Protect yourself from the next market correction by using our Successful Investor philosophy

To show the best long-term results, we think you should stick with our three-part Successful Investor program (but keep in mind that this approach is a starting point to success in investing, not a step-by-step blueprint):

  • Invest mainly in well-established, dividend-paying companies, with a history of rising sales if not earnings and dividends.
  • Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities.
  • Downplay or avoid stocks in the broker/media limelight. When stocks spend time in the limelight, they tend to become overpriced, and this leaves them vulnerable to a sharp downturn on any hint of bad news. Instead, look for stocks with hidden value that are less widely recognized—at least so far—as attractive investments.

What signs make you think the next market correction is coming? How soon do you think it will come?

Do market corrections concern you? Why or why not?

Comments

  • Protect yourself with stop loss orders. If a stock tanks due to poor earnings, the stop loss kicks in and sells the stock before the stock loses a significant amount of value. Look at NWL, which went from $50 July 2017 to $16 October 2018. A stop loss at the 200 day moving average would have sold the stock off at $38, preserving most of your cash as the stock went to $28, and allowed you to pick up the stock again (if you still believed in it) for $16.

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