Making Sense Of Market Correction

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Making Sense of Market Corrections

February 21, 2020

Episode Description
Interview With Jeff DeMaso and Brian Mackey

Market corrections are normal. But when do they signal something more, and how should they factor into your long-term investment plans?

Episode Transcript

Jeff DeMaso: Hello, this is Jeff DeMaso, director of research at Adviser Investments with another “Adviser You Can Talk To” podcast. Today I have as my guest Brian Mackey, who’s a senior research analyst at Adviser Investments. Brian has earned his Chartered Financial Analyst designation and carries a heavy load on the investment team. He’s involved in mutual fund research, individual stocks, and quantitative analysis. It’s no surprise he’s a go-to resource for colleagues and clients. So Brian, let’s get right down to it. What would you make of this market volatility?

Brian Mackey: First of all, thanks for the introduction. So I think the market volatility, this is a pretty standard correction in the markets right now. We’ve got some pretty cool research about how often we see drawdowns in the market, and we get drawdowns about of a 10% correction about every other year. Like clockwork it’s been almost exactly two years since the last 10% correction. So this is a pretty standard correction in the market.

Jeff DeMaso: So corrections happen, but it seems like in the market, at least in the media, they’re saying that interest rates and higher interest rates are why stocks have fallen. So is that the new paradigm, that higher interest rates equals lower stock prices?

Brian Mackey: That is definitely the story out there right now, and the reality is that if people fear that that’s the case, and that drives them to sell, then it can absolutely become true. It’s sort of a self-fulfilling prophecy. If you look at the longer-term data, our opinion is that, even if inflation does tick higher and interest rates go higher, it’s not necessarily a bad thing for the stock market. JPMorgan’s done some great research on this topic where they’ve looked at how changes in interest rates can affect the stock market. The basic conclusion that they come to is that when rates are low, below 5%, and the 10-year is at about 2.9% today. So anytime that it’s at rates where they are right now and rates go higher, it’s a sign that the economy is improving, and that tends to be a good sign for the stock market. It’s not until rates get above 5% and keep going higher that’s when either the economy is doing really, really well and the stock market’s kind of priced to perfection, or inflation is really kicking up well above 2% that we need to start worrying. We’re far from worried right now.

Jeff DeMaso: So kind of the idea that higher rates aren’t necessarily high rates just because we’re coming off such a low base?

Brian Mackey: Exactly, yeah.

Jeff DeMaso: Okay, all right. So you mentioned higher rates being a self-fulfilling prophecy. If higher rates are seen as being a negative for the market, what might be a catalyst for the market going higher?

Brian Mackey: We always talk about earnings and interest rates. Interest rates, when rates go higher, on the surface it’s a negative because bond yields become more attractive. Why would I own stocks when bonds are paying me large coupons? But earnings is the other side; we haven’t talked about that yet. Earnings are growing right now at about 15% year-over-year, and there’s no real sign that they’re going to start shrinking any time soon. Right now at least it seems the strength of earnings growth is going to overpower the effective higher interest rates, and that’s where we see things going.

Jeff DeMaso: Also in the media you mentioned earnings growing 15%, that’s great. But the economy is growing maybe 2 or 3%. How do we kind of square that, economic growth versus earnings growth versus market returns? Is it all like one plus one equals one or like the exact same?

Brian Mackey: Over the long, long term, you should see earnings grow with the economy. So the fact that earnings are growing 15% and the economy is growing 3% real and maybe 5% with inflation, that’s not sustainable. So we’ll probably see earnings growth come down to a more reasonable level. It tends to fluctuate quite a bit, and earnings growing 5% is still pretty attractive when you go out and buy bonds and you’re kind of locked in and there’s no growth of that income, whereas dividends can at least grow 5% a year. To me the fact that earnings can grow and continue to keep going higher tells me that stocks are still pretty attractive.

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Jeff DeMaso: We’ve been talking about why the market moves and the media has this obsession with always giving a negative narrative for why the market moved even if it’s trying to explain a 0.1% move in the market or whatever. Why do we have this need to define why with the market?

Brian Mackey: My favorite is when the market starts down in the morning and the headline is, the market is down because of X, Y and Z. Then something happens or nothing happens at all, and the market just turns around, and then all of a sudden the narrative has to change. The market was up because of A, B and C. So there’s always some type of narrative out there, and I think it kind of comes back to the biology of human beings. If you think back to the hunter-gatherer years when you ate a berry and it got you sick, that was a pattern that you noticed. So the next time you saw that berry you said, I’m probably going to avoid it this time. You see a scary animal in the distance, and you realize that last year that same animal ate your cousin. You’re going to start running a lot faster than before.

Seeking patterns is, I think, a part of who we are as human beings. The problem with that is that sometimes we see patterns that don’t really exist. We try to make a story out of something that isn’t really there. My favorite scientific study that I’ve come across on this topic is, rewarding mice versus humans, where they did this study where 2/3 of the time if a mouse went to the left a mouse could go either left or right. And 2/3 of the time the left option gave them sugar water, and 1/3 of the time the right option gave them sugar water. So the mouse quickly figured out, well if I go left all the time I’m more likely to get sugar. And sugar is sort of the reward. If they did that trial nine times, six times they would get sugar water. But humans, we’re a little bit different where we’ll see this pattern of 2/3 vs. 1/3, and we’ll try to guess what the next one will be even if it’s random. Humans do the same thing, and say we go to the left two times, and we were right, the next time we’re going to say, oh it’s got to be, we’ve got to go right to guess the next pattern.

So humans in that same experiment will get it right five times, whereas mice will get it right six times. That’s very similar to guessing if the market’s going to go up or down. It’s really kind of a random fluctuation, and it’s tough to guess. Really what I’m trying to say is that mice are better investors than humans. (laughing)

Jeff DeMaso: Well you say that it’s kind of a random guess, and I think on a day-to-day basis it probably is maybe 51, 52% of the days the market has been up.

Brian Mackey: Sure.

Jeff DeMaso: But over the long term if you look at one year, that percentage probably goes up to 60, 65%.

Brian Mackey: Yup.

Jeff DeMaso: You know, over a 10-year stretch the market has historically been up 80% of the time. So I agree that there’s some element of guessing, but if you extend your time horizon, you do kind of want to be like that mice and always go to the left. You want to expect the market to go higher over time.

Brian Mackey: Yeah, I completely agree. I was asked a question recently on a day when the market was down 4% last week. The question was, should investors be scared? My answer was, well it kind of depends. If you have a time horizon of one hour, than yeah, you probably should be a little scared because anything could happen in an hour, especially when the market’s real volatile it tends to the next day be pretty volatile. But if your time horizon is a 10-year period or longer, then you should be pretty excited about any kind of downturn you get knowing that the long-term results, as you said, tend to pretty positive for stock investors.

Jeff DeMaso: So it’s kind of know yourself. Are you a trader, are you an investor? They’re not exactly the same.

Brian Mackey: Exactly, play to your strengths, exactly.

Jeff DeMaso: So we seek patterns as humans and we’ve got also the caveman brain of trying to avoid danger and recognizing patterns for danger. Stepping back to kind of where we started maybe to wrap up is how should investors think about the recent decline, recent correction, that we’ve experienced?

Brian Mackey: I always kind of come back to the historical data. I think that’s a good way to set the expectations really. So we had a 10% correction. 10% corrections happen every other year. The real question is how often does that 10% correction then become a deeper correction and something, a real bear market that we should be worried about? The data there says that we’ll get a 20% decline about every nine or 10 years, and we’ll get a 33% decline or greater every 18 years or so. So in a 20-year period you’re going to have probably about 10 corrections of 10%, but only one of them will lead to a 33% decline, and only two of them will lead to a 20% decline. So the other ones, the vast majority of them, we tend to go right back up. I guess my answer is I don’t know what will happen in the future, but the numbers tell me that I am probably going to paid to be optimistic and expect stock markets to bounce. And they have kind of bounced back the last couple days. The numbers seem to be playing the way they should be.

Jeff DeMaso: That is interim and the short-term corrections are normal.

Brian Mackey: Yep.

Jeff DeMaso: Some corrections will lead to bear market but not all corrections do. Even most don’t. So keep your eye on the long-term horizon, your long-term plan, which should include expectations for some volatility.

Brian Mackey: Absolutely, absolutely.

Jeff DeMaso: All right, great. This is Jeff DeMaso, and I want to thank you for listening to another of our “Adviser You Can Talk To” podcasts. I’ve been speaking with Brian Mackey. If you enjoyed this conversation, please subscribe to our podcast, or check us out at adviseryoucantalktopodcast.com. Your feedback is always welcome, and if you have any questions or topics you’d like us to explore, please email us at [email protected] Thank you for listening.

Podcast released on February 21, 2020. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. For more information on each individual featured in this podcast, see the Our People section of our website.

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If you have a time horizon of 10 years or more, you should be pretty excited about any downturn you get.

Deputy Director of Research

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Making Sense Of Market Correction

The Technical Correction-What You Should Know

Market corrections are often very difficult environments to trade it. This is because near and long term factors are at odds with each other. For one reason of another these factors build until eventually one or the other comes out on top. In the recent months, speaking to the correction we have seen in the US markets, near term fears born on the back of geo-political concerns, Ebola, weak global economic data and crashing oil prices. These fears mounted, one by one, until they overshadowed the fact that long term economic trends are up and gaining momentum. This by no means is the underpinning of all corrections, merely my view on the current one. The thing that makes a correction so hard is that they show up quick and move fast once begun, a combination which makes it very easy for even savvy traders to lose sight of the longer term. However, if you can keep your emotions in check there are a number of profitable entries a binary trader can make.

Market corrections can occur in either a bull or a bear market. Corrections occur with regularity within any trend and can be profited from. They are a natural part of any market environment and actually help to strengthen the longer term trend. By definition a correction is a change that rectifies an error or inaccuracy. By extension a market correction is a change that rectifies an error or inaccuracy in market value. This can be due to sentiment or pricing and simply means that for one reason or another market prices were incorrect, and became fixed, correcting to trend. The very best thing is that corrections, like all aspects of technical analysis, are predictable and repeatable giving off regular signals. The hardest part about a correction is knowing when it starts so I don’t recommend trying to trade that move, it will be the follow up action where you find the most opportunity.

Opportunity In Correction

The most common way to judge a correction is by extent. Typically a market is not considered to have “corrected” unless it moves at least 10%, opposite the prevailing trend. This is evident in recent action. The markets were falling hard, and gaining momentum, when the Russell 2000 and NASDAQ Composite touched into -10% territory. This is important to take note of because you can use this number to predict support levels in future corrections.

Fibonacci retracement is perfect for measuring corrections

Look at the chart above. The Russel 1000 fell just a hair over 10% where it found strong support. Once the correction began savvy traders could have targeted this level for speculative positions and received near instant reward. The bounce can usually be traded over the next few days or week, until resistance is met and it will be met. Corrections don’t mean that the trend will continue immediately, just that it will eventually. What typically happens is a consolidation period and this is when I whip out the Fibonacci Retracement tool. You can see this on the chart above as well. Once the bounce begins you can use standard Fibonacci signals, one of which will be resistance. Look at the next chart of one hour prices. There are at least 7 clear Fibonacci entry signals over the course of 6 days with more expected.

Fibonacci provides multiple entries during corrections

In this example price action has retraced the correction more than 50%. This a very bullish sign but does not mean the index is moving straight up. In fact, based on the MACD, we can expect a retest of support and it might be a strong one. Price action in fact trading right in line with the 62.6% FR level and making a bearsish candle. This is a sign of resistance and the next possible entry point. A put from here can be expected to move into the money in the next few bars with downside targets in-line with the Fibonacci Retracements. My first estimate will be for prices to find support at the 50% line, but if it breaks prices will likely fall all the way back to test the full correction. This next chart is the same but dialed in to one hour candles.

Freak Out Or Make Money?

Well, I hope by now I have helped you to realize that market corrections are nothing to freak out about. In fact, in my view, corrections are great opportunities for quick witted, savvy traders to make some money. Like I said before, the start of correction is hard to judge and can create a panic of its own. This may cause you to lose a trade or two but once it becomes clear the market is fixing a problem you can correct those loses with some high probability trading.

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