Demystifying Market Corrections

When the market starts trending down, many investors tend to panic.  They see volatility as dangerous and formulate a belief that the market is just not for them.  These panicked investors perceive the correction as something wrong with the market as a whole and lose sight of the fact that for every stock listed, there is a company behind it.  Veteran investors have come to expect these periodic “corrections” to what can be considered inflated prices. Corrections happen all the time. After “big runs,” you should anticipate them.  It is a terrible mistake to pull out of the market when they happen.

Jim Cramer teaches that a particularly profitable strategy for dealing with corrections is to avoid the trap of being 100% invested in the market at all times.  At times when the market is tanking, cash that makes nearly nothing can look like a great investment. As Cramer put it, “Nothing feels as good as cash when the market is coming down.”  This is actually a critical element of his axiom of “selling strength and buying weakness.” When the market is surging upwards, the strategy dictates that you “trim” here and there to generate cash to be in a position to buy during the next correction.  

If you don’t do this trimming and hold on, you may fall into the trap of selling your winners to subsidize your losers. This naïve practice can wreck a portfolio by filling it with junk because all of the blue chips have been sold off. When you realize that a stock is junk, then sell it and take the loss.  Use what’s left to reposition into something great. The real key to all of this is to differentiate between bad companies with deteriorating fundamentals and good companies with deteriorating stock prices.

Don’t forget that companies with good bottom lines can go bad because of larger forces that are outside of management’s control.  Geopolitics, exchange rates, fed policy, and a host of other factors can make cause a once great company to lose traction. Don’t let your emotions get in the way of making rational decisions based on shifting fundamentals.  In a slowing economy, for example, you may see a consumer shift from premium brands to store brands that can hurt the bottom line of once great premium product companies. Drug companies that have been making fortunes for years can suddenly see their bottom line drop out of sight when a family of important drugs goes off patent.  If you confuse the shifting fundamentals with a market correction and buy more while the stock is “on sale”, you can lose big.

If your portfolio is composed of great companies with great fundamentals, don’t fear the market corrections.  Those great stocks will bounce back, ready to ride the next upturn.

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