Is Selling After a “Correction” Correct? – October, 2015

Financial professionals and analysts generally describe any stock market decline of 10% or more from a previous peak as a “correction.” Should investors sell to protect themselves from further declines, or should they consider market declines as an opportunity to purchase more stocks at favorable prices?

As happened earlier this year, stock prices in markets throughout the world fluctuated dramatically for the week ending August 27. On Monday, August 24, the Dow Jones Industrial Average fell 1,089 points—a larger loss than the “Flash Crash” back in May 2010 having a trillion dollar impact on global markets — before rallying to close down “only” 588 points.2 Prices fell further on Tuesday before recovering sharply on Wednesday, Thursday, and Friday. Although the S&P 500 and Dow Jones Industrial Average rose 0.9% and 1.1%, respectively, for the week, many investors found the dramatic day-to-day fluctuations unsettling. If you recall, similar volatility repeated the week ending October 2.

Based on closing prices, the S&P 500 market index of large cap U. S. stocks declined 12.35% from its record high of 2130.82 on May 21 through August 24. Assuming there a market “correction,” it is not clear without an expanded knowledge of financial history how investors should respond to that information:

  • A. Should investors take action by selling to protect themselves from further declines, or
  • B. Should investors consider it an opportunity to purchase equities at more favorable prices?

A short study of market history

How much did U. S. market index actually change over the last full year? Despite instant media access of market prices to captivate viewer attention, net price change for one full year as of August 31st was only 0.48%; as of September 30th, it was -0.61%–or just about flat for those investors not paying attention, perhaps with more worthwhile activities than watching daily changes of various market segments.

Based on longer term S&P 500 index data, stock prices have declined 10% or more on 28 occasions between January 1926 and June 2015. Obviously, every decline of 20% or 30% or 40% began with a decline of 10%. As a result, some investors believe that avoiding the large losses they fear can be accomplished easily by reducing or even eliminating equity exposure once the 10% threshold has been breached. Many of the new so-called “robo-advisor” programs automatically reduce market exposures when a “correction” occurs.

Market timing is an unreliable technique

The lure of market timing is seductive. If only we had the knowledge—or special access to that secret realm to which no other investors are privy except “us”– allowing “us” to sell stocks just prior to a big decline and safely hold cash while everyone else suffers losses, our long-run returns could be exponentially higher than staying invested at all times, and simply maintaining a structured asset allocation strategy with disciplined rebalancing to purchase stocks at then-lower prices.

Who wouldn’t want high returns with limited or possibly even no risk? Many financial advisors, hedge fund managers and some salespersons competing for commissions suggest—without directly claiming—either that know how, or promote some financial vehicle or scheme that alleges a special past ability to beat the market with astonishing prescience. Caveat emptor.

But any profitable market timing strategy is a two-step process, which must be successfully repeated over and over again, year after year:

  1. determining when to sell stocks (and which to sell), AND
  2. determining when to buy stocks (and which to buy) back.

Avoiding short-term losses runs the risk of missing even larger long-term gains on a rebound. Regardless of whether stock prices have advanced 10% or declined 10% from a previous level, they always reflect:

  1. the collective assessment of the future by millions of market participants, AND
  2. the expectation that equities in US and global markets have positive expected returns.

Exhibit 1 below shows that US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar. Draw your own conclusions for an informed strategy.

Contrary to the sincerely held belief of many investors and traders, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly.

The world is an uncertain place. The role of securities markets is to incorporate new political, social, meteorological, technological, financial or economic developments and so quickly transmit and aggregate information— both positive and negative, incorporating the past and speculating about the future—in the form security prices. Investors who accept dramatic price fluctuations as a characteristic of liquid markets and sufficient liquidity have an enormous advantage over those who are confused or unnerved by sudden and surprising day-to-day market events in response to unexpected news, or just trading blips.

Investors in financial assets committed to owning the associated market risks of long-term equity ownership—in prudently constructed portfolio strategies—are far more likely to achieve the positive long-term planning outcomes they desire. This is in stark contrast to those who merely rent their risks from the market seeking quick returns, selectively choosing hot stocks or ETFs or hedge funds as they chase prices upward, gambling they are smart enough (or smart enough to have hired someone else with a computer smart enough) to get out of crashing markets before everyone else can scramble for the exits.

Concluding our short study in market history

Lest investors or speculators, novice or veteran, young or old, should ever forget, the 28th anniversary of “Black Monday”, October 19th, 1987 is almost upon us. Without warning, the Dow plummeted almost 23 % in a single day, and investors endured a 45 % decline for October. Speculators were traumatized for years after. Yet for disciplined investors following an informed strategy, the Dow itself still finished 2.2 % higher than it began, and the broader S&P 500 Index ended 5.2 % for the whole year. As for those many speculators and traders back then whose portfolios suffered horrible torment, or for all those uninformed investors who panicked and simply cashed out of their stock holdings, R.I.P. With super high-speed computers on dedicated broad bands using certain algorithms trading in milliseconds today, that kind of “flash crash” could potentially happen in seconds, with or without the aid of a cyber-attack.