The Potential for a Market Correction

I have started to batten down the hatches.  Why?

Howard Marks - "Here They Go Again"

Marks, the Chair of Oaktree Capital Management, identifies several worrisome trends:

• some of the highest equity valuations in history
• the so-called complacency index at an all-time high
• the elevation of a can't-lose group of stocks
• the movement of more than a trillion dollars into value-agnostic investing
• the lowest yields in history on low-rated bonds and loans
• yields on emerging market debt are lower still
• the most fund raising in history for private equity
• the biggest fund of all time for levered tech investing
• billions in digital currencies whose value has multiplied dramatically

Another set of ingredients is listed here:

The Warning Signs are There

There is no shortage of commentary on the potential for a significant market correction.  There is no way to predict when a correction will take place.

Some potential strategies:

• reduce exposure in equities and go to cash
• have the patience to wait for up to three or four years for a correction with the thought that it could be profitable to re-enter the market when valuations are more attractive
• economize: reduce spending in the meantime and make no major long-term financial commitments

Here is an extract from a previous post which was published in January 2016.  It is all the more relevant at the present time. 

When to Sell - The Thinking Process

The decision to sell is much harder than the decision to buy for a variety of reasons. On the one hand, it can be a recognition of "failure" in the event that the selling price falls below the purchase price. On the other, it forestalls the possibility of further gains if the selling price increases above the purchase price.

Most treatises on the matter start by listing reasons for selling. Many of the following reasons are inter-related:

• stock becomes "over valued"
• the onset of adverse changes in management and boards of directors
• company's failure to deliver on its business plan e.g. botched product launch, inability to secure financing etc.
• company's ability to compete declines
• a take-over makes the assets less desirable
• a "major" event causes severe (and potentially irreparable damage) to a company's business e.g. major legal actions with major settlement costs
• undesirable external changes in the company's operating environment e.g. adverse socio-political developments
• need to rebalance a portfolio in the event that the price runs up significantly

• a better investment opportunity emerges
• need to meet margin calls
• need for cash for personal purposes
• tax loss at the year end

I suspect that most investors sell out of fear - fear that they will experience yet further losses if they hold on in an environment of general market pessimism.

Thinking About Selling Should Start Before the Purchase

This is the key lesson I have learned. I'll use an analogy. A few years ago, I snowboarded on a large western mountain, my first time on anything with a vertical over 1000'. It was a bit intimidating until I had a chat with an advanced skier at the head of a long run. His practice was to visually scout out the slope beforehand: to look for changes in gradient, snow conditions, light etc - every thing that might affect his run. He then charted a mental path down the slope, noting points where he would turn, reduce/increase speed and potential bailout points if things got difficult. This done, he set out way points to guide him. His other piece of advice was to ski only to the end of the line-of-sight path and to stop and lay out another line once another part of the slope came into view.

I started to use this approach and found that life on the slopes became a lot easier and more enjoyable.

It's much the same with investing, especially with respect to the decision to sell.

• I state my investment thesis
• I establish some "way points" and monitor them closely
• If the course of the company changes I start to investigate the validity of my investment thesis
• The investigation may cause me to sell, buy more, or revise my thesis in light of further information e.g. a decline in the stock price may be the result of a transitory condition
• At yearly intervals (more or less) I review my investment thesis - akin to surveying the next line of sight on the slope.

It is very important to define one's investment horizon. For most of my investments, the horizon exceeds five years. It is largely the result of the type of company I invest in - cyclical resource-based enterprises or others where businesses move more slowly e.g. the North West Company. As a result, I am prepared to accept considerable variation in the price of a company's stock. The current decline decline in the stocks of Deere and Rocky Mountain Dealerships is a case in point. At some point, the agricultural cycle will recover along with the price of these stocks. I see no reason to sell now and try to time the market. My original investment thesis has not changed.

On the other hand, investments in other types of businesses involve shorter time horizons. High tech enterprises are an example: the risk of technological obsolescence or loss of market share to competitors often creates volatile circumstances for investors. In the case of precious metals, I have noted that prices are volatile. I have decided to speculate but only with funds I am prepared to lose if everything goes south ... and never to use leverage. In this instance, my waypoints differ from my other investments.

The central point is to develop a "mental model". It will differ for each investor in accordance with variables such as a person's tolerance for "risk" and "volatility", the sector, and the reasons for investing. It is more of an art than a science.