Rooting for a Stock Market Correction

There have been four stock market corrections (a decline of 10 percent or more from the recent high) during the current eight-year long bull market. According to research dating back to 1900, corrections have occurred about once a year on average, and lasted on average about 115 days. Over the past thirty years or so, the S&P 500 has seen 21 corrections. Talk is increasing that correction number five of the second longest bull market on record, is just around the corner. If you are a long-term investor, you should be rooting for a correction. After all, wouldn’t you rather buy stocks at a 10 percent discount to where they are today?

The reason most often cited for the potential decline is the unwinding of the so-called “Trump Trade,” which has driven up US share prices by about ten percent since the election. The rally has been attributed to three specific potential Trump Administration policies.

  • Individual and corporate tax reform: Investors, especially those with higher incomes, are likely to redirect savings into the markets. Businesses would be expected to use their newly found tax savings to reward shareholders in the form of bigger dividends.
  • Infrastructure spending: It doesn't matter whether it's private or public funds, because $1 trillion in spending will likely provide a boost in sectors like construction and materials.
  • Loosening of regulations: For many industries, like banking and energy, these changes are expected to amount to huge savings.

But after suffering a stinging defeat on healthcare, investors are now questioning the ability of the Trump Administration to enact these policies. And given that valuation levels show that stocks are more expensive than their historical averages (companies in the S&P 500 are trading at an average of 21.5 times the past 12 months’ of earnings, above the 10-year average of 16.5, according to FactSet), now might be the perfect time for the stock market to take a breather.

Whether or not we do get a correction this time around, there will be a time when markets slump. When they do, you might want to keep this list of three simple investor action items that can guide you through both good and bad times.

  1. Keep Cool, Sit Still and Do Nothing! There are two emotions that influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed. To guard against this cycle, stick to your game plan and avoid making changes to it. As Benjamin Graham said in his 1949 masterpiece The Intelligent Investor, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
  2. Maintain a diversified portfolio…and don’t forget to rebalance. To prevent emotional swings from robbing your performance, create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities. The hardest part of clinging to the plan is living with certain parts of your portfolio underperforming at times. The payback will come, when market events turn those previous dogs into champions.
  3. Maintain a healthy emergency reserve fund. Bad luck can occur at any time. That’s why it’s important to have ample emergency reserve funds (6 to 12 months of expenses for those who were employed and 12 to 24 months for those who were retired). A cash cushion can allow you to refrain from selling assets at the wrong time and/or from invading retirement accounts.