Category: Best Of

Corrections of at least 8% in the major indexes happen at least once a year almost every year. Here are some of the wisest sayings about market corrections that I recall. You could add your own in the comment section below.

1. Market corrections make people a lot of money. They just don’t know it at the time.

2. Corrections come a lot slower than anyone expects, but once they happen they escalate faster than most could imagine.

3. Corrections are healthy only when they happen to other people’s stocks.

4. 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.

5. At the lowest point of a correction, the fear of losing is substantially higher than the fear of missing out.

6. 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 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.

7. “You don’t need analysts in a bull market, and you don’t want them in a bear market.” – G. Loeb

8. “The market is better at predicting the news than the news is at predicting the market.” – G. Loeb

9. Bottoms are made by heavy buying, not heavy selling. Stocks not going down on what appears to be bad news is a positive sign.

10. “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

 

 

Two things happen when enough people react to a prediction:

1) the prediction comes true faster than it otherwise would under normal circumstances.

2) the prediction doesn’t happen at all.

Let’s take a look at two cases that cover each of the aforementioned scenarios:

Scenario 1: If enough people believe in the bright future of a company, they start bidding up its share price even if it is still losing money every quarter. The higher stock price will allow that company to hire the brightest employees and management; to buy promising smaller competitors, which will lead to a better market position. The overall improvement in profitability will be accepted as a positive feedback by the market and even more people will buy this company shares. Everything will happen a lot faster than it otherwise would. In this case, the initial expectations of a brighter future could turn into a self-fulfilling prophecy. When good market faith meets smart management, a story stock could appreciate very quickly.

Scenario 2: If enough market participants believe that there’s a major correction coming around the corner, many would simply buy put options to protect long-term positions and ride out the storm with a minimum drawdown. One could argue that if enough people believe there’s a deep correction coming, everyone will sell and actually cause this correction to happen faster and be even bigger. The truth is that funds that actually move markets don’t go to 100% cash. They just reallocate capital between less liquid, but more lucrative asset classes and hedge. Since everyone will start buying protection, volatility will spike. Equity prices might not drop more than a few percent because most funds would be already protected and they won’t sell their positions. Put options will expire worthless. Correction predictors will be made fun of. Everything will go back to normal. By definition, deep market correction always comes by surprise for most. If enough people expect a correction and act on their perceptions, it will either not happen at all or it will be much shallower than most expect. I’d be a lot more concerned when the market is down 5% and everyone is blindly buying the dip than when the market is down 5% and implied volatility is through the roof because everyone is afraid and buying protection.

When volatility picks up, we should become less active and move slower. Hedge fund manager Frank Teixeira has good anecdote on the subject (ht midnight trader)

Most people think that Titanic sank because it hit an iceberg, when the real reason was because it was traveling too fast. The Titanic was traveling at a high rate of speed when it crashed into that iceberg. The ship was plotting a course through freezing waters. It was dark. Yet it didn’t alter its speed. Not exactly a great strategy– and certainly not smart risk management…

Many trading issues come for two reasons – over-trading and under-trading. Over-trading comes when we chase sloppy setups in unfavorable market environment. Since losses are more frequent and winners are smaller, it is easy to justify that trading more and bigger should compensate. The end result is usually a big drawdown. And what happens after a big drawdown? People are so scared to trade that they miss perfectly great trading opportunities when they start to arise. Equity selection, pattern recognition and risk management are essential stepping stones of consistently profitable trading, but they are not enough. Knowing when to be super aggressive and when to stay down is half the battle.