Broker Check

Corrections are common and by definition are buying opportunities...

| May 07, 2017
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Corrections are common and by definition are buying opportunities, but humans are wired to sell into them…

A stock market correction is a temporary decline in the stock market of 10% or more, which does not interrupt the uptrend in the stock market. Corrections don’t last long and the market recovers and continues its uptrend; hence, corrections are buying opportunities. Investors should certainly not sell into the corrections, but they do.

Corrections are common…

The table below covers declines in the S&P 500 from 1946 to 2016. Pullbacks of 5% - 10% occurred very frequently, 58 times during those 70 years, but markets on average quickly bottomed in a month. During this period, there were 22 corrections of 10% - 20% and the markets on average regained their footing in 5 months. There were 12 bear markets, where the markets dropped 20% or more, and these declines usually took 12 months for the markets to stabilize. In all instances, the markets recovered to go to new highs, but humans, in general, sell when markets decline and miss the recovery.

Humans are wired to sell…

We are here today because our ancestors were risk averse. Risk in their times meant running away from packs of wild wolves as they approached. Under stress, our ancestors’ cortisol levels (a stress hormone) spiked, allowing them to run faster and longer to survive. Today, the risk of being attacked by packs of wild wolves are rare, but stress due to bear markets, corrections and pullbacks are prevalent. Our stress levels are amplified by our “fear based 24/7 media” and our smartphones that allow us to always stay connected. As cortisol levels spike from the stress of price declines, investors capitulate and sell.
You can see this in the chart below as investors reduced their investment in stocks as the 3 year return for the S&P 500 declined, when it would have been better to increase their percentage in stocks. Conversely, they increased their equity exposure as the dot.com bubble was about to peak and burst. So it seems very difficult to follow Warren Buffett’s advice to be “fearful when others are greedy and greedy when others are fearful”.


Focus on dividends and not price…

Professional investors do not look at the price of a stock in isolation. They look at the price of a stock relative to its dividends. As the price of a stock drops it becomes a more attractive investment as its dividend yield (dividends/price) rises. A stock with a $2 dividend where its stock price drops from $100 to $50, becomes twice as attractive as its dividend yield has doubled from 2% ($2/$100) to 4% ($2/$50). A 4% dividend yield is very enticing during such low interest periods as now, which will cause investors to buy the stock.
Market pullbacks and corrections will always occur. So when the next price decline hits and your elevated cortisol levels will urge you to sell…call us for lunch to talk about dividend yields and the buying opportunity we have been handed by sellers.

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