You can’t predict stock market corrections, and trying to will inevitably hurt your returns
Stock market corrections are temporary setbacks in stock prices.
There is a difficulty faced when trying to predict stock market corrections. The task relies on a lot of guesswork. On the whole, it does more harm than good to investor finances.
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Stock market corrections 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.
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.
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.
P/E ratios and stock market corrections
Some investors try to predict coming stock market corrections by comparing current and past p/e ratios (the ratio of stock prices to per-share earnings). To do that, you have two types of p/e’s to work with.
One p/e type uses an historical “e”—past earnings. The drawback to this approach is that the market responds much more to future events than to historical events.
The other p/e type focuses on a future “e”—earnings forecasts. The trouble here is that nobody can consistently predict future earnings for individual companies, let alone earnings for the market, as a whole. Even if you had that superhuman forecasting ability, you could still guess wrong on market trends and corrections. That’s because p/e ratios rise and fall unpredictably.
Right now, p/e ratios vary widely, depending on what group of stocks you look at. For example, p/e ratios in the Resources & Commodities sector are high, because earnings are depressed by the general low levels of many commodity prices.
P/E ratios are just one measure of value
Successful investors treat p/e’s as just one of many tools for conducting stock research, not a deciding factor. That’s because by themselves, p/e’s can steer you wrong on individual stocks, and on the market in general. As well, there are lots of stocks out there that are cheap on a p/e basis. But many will remain cheap — their share prices won’t be rising any time soon.
When conducting stock research, you need to ask yourself if a p/e is telling you something by being unusually high or low. In the worst cases, buying stocks with low p/e and thinking that alone means you’re buying value, is often like boarding a train before it derails.
Stock market corrections are a near-constant risk
Market corrections are a near-constant risk. Unpredictable, unexpected political or international events can trigger them. You’re better off to disregard this risk. Instead, with our portfolio management clients, we focus on their investment goals, financial circumstances and temperament. We base investment decisions on the quality, diversification and balance of the stocks in their portfolios.
There are times when I suspect the market is headed for a correction. I don’t guess right every time, of course—neither does anybody else. In any event, this is not one of those times. Instead, we see reason to be optimistic on the long-term stock-market outlook. That’s when successful investors make most of their profits. But you only make money if you are in the market.
With all the Trump news this week and the impact to the markets, have you been thinking about going more into cash?
