833-346-5433

Oct 25, 2018

Corrections and the Nature of the Markets

By Gene Balas

Photo credit: Getty Images

Recently, an element of risk reappeared in the investment markets after an unusually long absence. Your United Capital adviser, supported and updated daily by an in-house research team, is there to help you make sense of the week and help you stay focused on your FinLife® goals and not the vagaries of the market.

Currently, markets around the globe are selling off due to worries ranging from trade policies and tariffs to rising U.S. interest rates to geopolitical concerns. Rather than be alarmed, however, we should consider whether this is merely a return to more “normal” conditions, not necessarily a harbinger of worse to come.

Why do we say a return to more “normal” conditions? First, let’s think about the nature of investing and the relationship between risk and return. Furthermore, recall that risk and uncertainty are related: the latter begets the former, and with more uncertainty, the potential for future payoff may also be greater.

We have all been vulnerable to forgetting the nature of risk and uncertainty in the markets; the Federal Reserve’s interventions into the markets has pushed the stock market seemingly straight up since March 2009, with just a couple corrections in between.

For with higher expected returns, we must expect – welcome, in fact – volatility, as that is the mechanism through which investments ultimately find their true value. When discussing corrections, we must consider three basic issues:

  • why they exist,
  • why they are natural, and
  • why they are necessary.

Corrections exist because facts become more widely known and understood, or alternatively, they change altogether. News flows are constant and are almost always unpredictable. Random events confound even the most carefully-made forecasts, which then must be discarded. Conventional wisdom is reexamined, old constructs become obsolete, and new data provide investors with deeper ways of thinking about an investment, or even the markets as a whole. Armed with fresh knowledge, investors may change their minds. And that may mean responding with “sell” instead of “buy.”

Corrections are natural because the data do change and people, in turn, change their minds in response. In a static world, there would be no corrections – nor would there be many opportunities, either. In that world, all investments would always be priced at their “fair value” and would never deviate in a way to provide an entry point to buy a new opportunity. Investors constantly research, analyze, and evaluate investment opportunities. Information on those opportunities is constantly being released and thus is constantly changing. Being early to capitalize on that changing information means some investors are quick to act – and when they all act at once, then the market may either surge higher or plunge lower. It is a natural course of action for market participants, upon realizing the same new information, to act quickly to buy or sell.

Corrections are necessary because it is through this mechanism that risk is fairly priced. What do we mean by this? Quite simply, stocks, bonds and other investments are determined by what investors are willing to pay for them; this depends in turn on what people expect will happen in the world. The more uncertainty there is, the lower the price one is willing to pay for an investment, because there are more ways that the investment can be pushed off course. In this situation, the majority of investors want a greater degree of protection when buying a stock – and that means a lower price. A correction, thus, is a way in which a sign that says “Special! On Sale!” is hung over the market, perhaps signaling buying opportunities. Indeed, it’s often the time when many investors go shopping for things they might not otherwise have bought when they were more expensive. It’s simply how the market works, much as in a department store.

In fact, it’s downright abnormal not to have corrections. We’re quite overdue, in fact. We’ve become complacent, forgotten how they feel or even what they look like. Having one, or even more of them, actually, would be a return to normal. In this case, “normal” means an environment with more volatility; that is, the very thing which investors undertake in order to receive the returns they expect. It’s a natural, expected, and customary tradeoff.

Corrections happen, or at least they once did, quite often. Using daily data of the S&P 500 since 1968, Ned Davis Research has detailed the nature of corrections as follows:

SOURCE: Ned Davis Research Group, Inc. on July 31, 2015 at www.ndr.com. The U.S. stock market is represented by the MSCI U.S. stock market Index.

Of course, bear markets are also normal and useful, however much we dislike them. We will have another, but nobody can predict in advance when the next might occur. Historically speaking, using monthly data since 1869, Ned Davis Research details that the typical bear market lasted about 17 months on average and delivered a -38% return, not annualized. But the good news is that between bear markets, bull markets lasted for almost nine years, having delivered an average return of over 17% per year.

Having discussed the nature of a correction, what does it not mean? For starters, it generally isn’t anything to be overly concerned about, for reasons we just explored. It also doesn’t necessarily signal any broader problems with the market or the economy. We can – and often do – have a solidly growing economy and corrections that occur in the midst of those expansions.

What a correction in the current environment might mean is that investors looking under the surface discover there actually is uncertainty in the world, after all. This is true even if reasons for optimism about the U.S. economy abound. And since there is always plenty of uncertainty in any environment, you will probably see more ups and downs going forward.

Having more ups and downs and returning to a more normal investment certainly should not prevent you from being optimistic. Moreover, a return to a more normal level of volatility should not be a reason to discard a carefully crafted long-term investment strategy. We are here to help you stay the course, if that is right for you. At the same time, if the events of recent weeks have sparked new insights in what might work for you, going forward, United Capital offers strategies that serve the full range of client needs: from lower volatility strategies to more aggressive, opportunity-seeking strategies. If you have any questions or concerns, or would like to reevaluate your investment strategy, this is a perfect opportunity to visit with your United Capital financial adviser.

Definitions

S&P 500: An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. The S&P 500 is a market value weighted index – each stock’s weight is proportionate to its market value.

The Dow Jones Industrial Average: This index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

Disclosure

Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The opinions expressed in this article are those of the author and not necessarily United Capital Financial Advisers, LLC. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.

Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

© 2018 United Capital Financial Advisers, LLC. All Rights Reserved

www.unitedcp.com

United Capital Financial Advisers, LLC (United Capital) provides financial guidance and makes recommendations based on the specific needs and circumstances of each client. For clients with managed accounts, United Capital has discretionary authority over investment decisions. Investing involves risk and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this blog is intended for information only, is not a recommendation, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. This blog is a sponsored blog created or supported by United Capital and its employees, organization or group of organizations. This blog does not accept any form of advertising, sponsorship, or paid insertions. Certain authors of our blog posts may be influenced by their background, occupation, religion, political affiliation or experience. It is important to note that the views and opinions expressed on this blog are that of the owner, and not necessarily United Capital Financial Advisers. As a Registered Investment Adviser, United Capital does not allow any testimonials on their blog, and any comments deemed as such United Capital will remove.

United Capital does not offer tax or legal advice; therefore all articles should not be taken as such. Please consult legal or tax professionals for specific information regarding your individual situation. All referenced entities in this site are separate and unrelated to United Capital. Any references to any specific commercial product, process, or service, or the use of any trade, firm or corporation name is for the information and convenience of the public, and does not constitute endorsement, recommendation, or favoring by United Capital.