Deep corrections last long enough to condition people to sell their winners quickly because of frequent reversals in direction.
Some say that If you don’t have a plan, you will become part of someone else’s plan. Well, the problem during corrections is that many are not able to follow their plan – not because they don’t want to, but because the market doesn’t let them. Hint – the gaps above and below your stops. The cure is to decrease our position size and the frequency of our trading.
Market corrections come slower than most expect, but once they arrive – they escalate faster than most can imagine. Peter Lynch’s words are a good reminder here – “far more money has been lost while preparing for corrections than during the corrections themselves”. Keep in mind that most of Lynch’s career as a mutual fund manager took place during a secular bull market.
The market is not going to be healthy all the time. 8% to 20% correction happen at least once a year every year. Steep corrections create incredible opportunities, but you have to protect your capital in order to take advantage of the recovery.
Once in awhile, a correction will turn into a bear market. They say that both bulls and bears lose money during bear markets – bulls, because they stubbornly hold to favorite story stocks while they are crashing and then they give up near the bottom; bears – because they get squeezed by frequent face-ripping rallies under declining 200-day moving averages.
All corrections feel the same. In the beginning, people don’t believe them, then as prices continue lower and weakness spreads to more sectors, fear escalates and it leads to forced liquidation. Forced liquidation means selling, because you have to, not because you want to. Smart investors dream to be on the other side of forced liquidation.
At the lowest point of a correction, the fear of losing is substantially higher than the fear of missing out.
During corrections, correlations often go to 1.00, which means that stocks move together up and down disregarding of individual merits. If a stock manages to hold its ground and consolidates through time or even make an attempt to make a new high, it is likely being accumulated by institutions. Because of the nature of their size, many institutions prefer to buy on pullbacks and during market corrections. Selloffs provide liquidity that masks their accumulation. Once the pressure from the general market is removed, those stocks tend to outperform.
Bottoms are made by heavy buying, not heavy selling. Stocks not going down on what appears to be bad news is a positive sign.
“It is not entirely clear what causes deep market corrections, but without them, many of the best performing long-term investors would have never achieved their spectacular returns.” – Peter Lynch