Reality Check: Average Market Corrections

"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

I'm a logical thinker, which is both strength and weakness.  With regard to financial markets, logical thinking has helped me make more good decisions than bad.  Where my logic is challenged is when faced with an irrational crowd: I have to minimize my ego that wants to ignore herd behavior and remember that the crowd is "right" more than it is wrong, at least with regard to the movement of financial markets.  Perhaps better wording is that the crowd dictates the movement of asset prices; irrationality (psychology) is at times more a factor than actual economic conditions.

"Histories make men wise; poets, witty; the mathematics, subtle; natural philosophy, deep; moral, grave; logic and rhetoric, able to contend." Sir Francis Bacon

The logical thinker, in the case of the current financial crisis, will look to history, not as a basis from which to make a decision, but as a place to begin the thought process.  The reasoning is that crowd irrationality will at times become so far removed from reality that a logical, rational investor can do quite well to recognize disconnects in stock price movement.  The challenge, of course, is to guess how long the "disconnects" will last.

Here are some historical averages, thanks to a weekly newsletter that Fidelity sends to investment advisors, that may not predict the future but perhaps may give the rational, logical investor some perspective on market "corrections."

• Average Frequency of Market Corrections: 5% corrections occur 3 times per year, 10% corrections once per year, and 20% declines occur once every 3.5 years.
• This is the first 10%+ correction of the year.
• The market is 11.3% off its recent peak and 12% off its cycle peak
• Can we go down further? Yes, but big corrections (>12%) are normally associated with recessions or markets that are overvalued.
• The debt ceiling crisis has passed.
• 75% of companies beat earnings estimates.
• Oil is back under $90.
• Car sales are up 5.8% year over year.
• Signals from the bond market: Credit spreads are currently holding in well and all recessions have been preceeded by a flattening of the yield curve (relation between the interest rate and the time to maturity of the debt for a given borrower), which is not currently the case.

For added perspective, this information came from a source (Fidelity) that has an incentive to incourage investors to put money back into the market.  The key takeaway from this is that investors, reflected by current stock prices, are "anticipating" recession.  If the crowd is "right" we will re-enter recession.  If investors begin to see evidence that the US economy will avoid recession, stock prices will climb again.

In summary, irrational behavior can create the event that was initially not "real"--a self-fulfilling prophecy.  This is where neither logic nor emotion are useful for decisions; it is perhaps a time for another imperfect decision source--intuition.

"Those who have knowledge, don't predict. Those who predict, don't have knowledge." ~ Lau Tzu

My intuitive thought is that this is a severe but short-term correction.  With that said, however, I am mostly a passive investor; I believe the best reaction in extreme conditions is no reaction at all.  Therefore, I never make predictions.  The best decisions are made in the planning stages prior to the emotional event.

What are your thoughts now?  Is this a short-term and classic case of crowd irrationality compounded by a fast-moving and ever-present media?  Is crowd behavior creating a self-fulfilling prophecy (e.g. falling stock prices worsens consumer spending, which harms the economy)?  What are you doing now? 

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Related: The Rhyme of Irrationality

Comments

[Leone]

Whilst I agree with everything you say, there is one aspect that seems to be often overlooked by market participants. The price action itself. I believe this is a form of analysis, long discarded, that in my view says more about the emotional state of a market than any fundamental or technical analysis can. Irrational behaviour can last a moment, possibly a day or two and will subsequently reversed. A rout that lasts 3 weeks (4 if we take the top of the week of 07/18) has deeper roots. As always, history will tell us why. There are instances when deep corrections were subsequently reversed fairly quickly. The crash of '87 or '98 spring to mind. But in both instances, there was a catalyst for the reversals. Similar bullets have been used more than once since 2009 with little 'real' economic impact. Does anyone seriously believe that QE3 will do the trick? Too many events around the world, and i'm talking economic events (which differe from area to area) not to mention social ones seem to be aligning to create the perfect storm. If we're lucky, the changes will be gradual but the Pied Piper will eventually need to be paid. How long can we postpone?

[Kent @ The Financial Philosopher]

I agree, Leone, and I believe that chaos is a part of order. To clarify, what appears to be irrational or random now, is actually a small part of the overall order of life--it is nature...

[J Romick]

Leone and Kent, the price action should be part of the order. Does it tell more or less, I don't know. But check out the portfolios maintained on this site: a simple 6 assets (no surviability etc., simple US stocks, foreign stocks, emerging stocks, real estate, commodity, bonds) price momentum portfolios perform so well, does it mean price action tell a lot? Efficient market hypothesis (EMH) says prices say it all. See this http://www.myplaniq.com/LTISystem/f401k_view.action?ID=1,148