Three ways to navigate the correction
It has been an interesting two weeks in global markets. While this can be an unsettling period for investors, it can also be a great chance to form a better understanding of the market and its underlying risk.
In this regard, here are three key takeaways from the latest action in the markets we think will help investors navigate stormy waters.
CORRECTIONS ARE THE ENEMY OF THE INVESTMENT INDUSTRY
After a record amount of time without a pullback the recent correction has sent shock waves through the financial ecosystem, leaving industry pundits and market strategists scrambling for a reason for all of this selling. Most have responded with their respective charts, graphs and historical examples showing that this correction has surely come to an end and therefore a great chance to buy the dip.
This isn’t surprising as corrections are the enemy of the investment industry. This is because the industry has been built on selling investment products to the public and products don’t sell very well when investors either maintain their positions ( buy and hold) or worse, move to the sidelines.
The rapid and prolific growth of the ETF industry has probably made the situation even worse as it’s much easier now for investors to give into their inner FOMO (fear of missing out), all with a simple click of a button. Witness the recent large flow into marijuana, cryptocurrency, robotic and artificial intelligence ETFs.
Investment managers also don’t profit by managing cash or corrections because if they are wrong and miss out on a market rally they face what is known as “career-risk,” meaning they will lose their clients who find it important to track the market. So when a correction occurs the most likely response is advising their clients not to worry as they rarely happen and when they do they are to be bought up.
CORRECTIONS ARE SIGNS OF A HEALTHY MARKET
Corrections are a sign of a properly functioning market as they factor risk into capitalal-location decisions and thereby create efficiency by separating those who buy on the premise of recent historical returns from those who undertake thorough diligence to identify mispriced opportunities.
The problem is that central banks have kept interest rates at ultra-low levels for a long time despite their respective economies having fully recovered. This is because their goal is based on inflating assets such as the stock market and real estate in order to create the wealth effect that will work its way through to the average consumer. However, inflation has remained subdued while the perception of risk has been altered, providing investors with a false sense of security.
As a result, we have seen extremely crowded trades by quant funds, retail investors, and futures speculators. This includes U.S. and international equities, commodities such as crude oil, currencies like the euro and short volatility funds in which the ratio of buyers has outnumbered sellers by a wide margin — until recently at least.
We worry a lot about the consequences of going so long without a correction. Short volatility funds generated great returns for a number of years and suddenly overnight some lost more than 80 per cent of their value and are facing termination. In oil markets, speculators now own more than 1 billion barrels of oil and fuels, something I have never witnessed in my career. What happens when this unwinds?
CORRECTIONS ALLOW FOR AN OLD-FASHIONED GUT CHECK
Investors can use times like these as a chance to gauge just how risky their portfolio is by measuring how much in absolute dollar terms it corrected during the past week. They then have a choice on how to respond.
For those who find it important to track the market then this indeed may be a good opportunity to buy the dip. But be prepared to own the correction if it continues.
Another route would be to use this as chance to risk-manage and diversify one’s portfolio. This could be done a number of ways including taking profits out of those segments of the market that are still overly crowded and reallocating to those areas that may be oversold and undervalued.
In either case, it helps to be objective as possible and that means understanding risk and not allowing your perception of it to be influenced by the investment industry or central banks.