Why Market Corrections Are Great and Necessary (Besides Buying Low)

[Kaspian]

From the immortal words of Garth Turner this week (truly a great Canadian):

After all, a correction of 10% or more for the Dow or the S&P doesn’t mean the US economy is sick. It’s not. Instead, after hovering around record highs for the longest period of time in 90 years, markets blew off some gas. That’s how dangerous bubbles – which pop with far worse, longer-lasting consequences – are avoided. Like the one brewing with Canadian real estate.

But market declines spook people. We think the worst. The media and the bullion-hocking newsletter guys know that. Human nature clicks in – the same hormones which makes people want things that keep getting more expensive. Once again the emotional are led to slaughter – those who bought high end up selling low. A few days, weeks or months later it all passes. Only the realized losses remain. Poor little sods.

Source:  http://www.greaterfool.ca/2015/08/24/no-kidding-2/


It’s only human nature that’s primitive. People want stuff that goes up. They fear things that go down. Investors lose sight of the fact we need corrections like this to keep dangerous asset bubbles from forming. They’re normal and beneficial. But with each decline people fret things are going to zero, just as they believe every advance will be permanent. There’s but one constant. They’re always wrong.

In the past four years the stock market has corrected by 5% or more seven times. On each occasion there was pissing and moaning in the steerage section of this blog. And every time this marked an attractive point to enter the market, which continued to advance. The pullback now is exactly in line with the average of all the others.

...

Here’s a five-year chart of the major US market. So just imagine if you’d mistaken the big dump in 2011 (the US debt ceiling crisis) for something other than a useful correction.



Source:  http://http://www.greaterfool.ca/2015/08/21/get-a-grip//

[leostrauss]

Except the US market is anything but fair valued at this point. The Shiller P/E is still somewhere between absurd and insane meanwhile the 10 year treasuries pay less than 2%. So the bubbles are already here, they are everywhere you look. Growth stocks, dividend stocks, bonds, precious metals, real estate. Everything priced for perfection for the next couple of decades. I'll wait for this shit to mean revert before deploying any more money into ANY market.

[Eric]

Everything is in a bubble?  LOL!

[leostrauss]

Keep LOL-ing. I will keep waiting until good deals do appear. Time will tell which one of us got it right. My bet is that i will be able to buy S&P500 with the P/E under 14 in the next few years and 10 year bonds yielding over 5%. And if that doesn't happen I'm only out a percentage point vs guaranteed investment vehicles. Meanwhile, you keep dreaming of 7% annualized returns from a market that is overvalued 30% 

[Kaspian]

Umm... What's overvalued in the S&P 500 now?  "Everywhere"?  Besides maybe Facebook?  ...Johnson & Johnson?  Heinz?  Visa?  Xerox?  It's all one giant bubble?  Surely you can't think that?

Maybe you're not taking inflation pacing into account?  :/  An inflation-adjusted S&P shows not much that looks like a giant bubble.  ...Unless we're in a 30-year bubble which started in 1993.  And that wouldn't be a bubble so much as beach ball.

[leostrauss]

http://www.multpl.com/shiller-pe/

http://www.multpl.com/s-p-500-dividend-yield/

http://www.multpl.com/s-p-500-price-to-sales

And lest we forget the current bond bubble courtesy of our central planners:

http://www.multpl.com/10-year-treasury-rate

[Kaspian]

http://www.multpl.com/shiller-pe/

http://www.multpl.com/s-p-500-dividend-yield/

http://www.multpl.com/s-p-500-price-to-sales

Link #1 & #3 look normal to me.  ...And I have no idea how PE ratio makes an investor money anyway.  #2 Dividend yield:  Ummm..  I'm pretty sure (by definition) dividend investors don't buy a market index fund?  Though I could be wrong and there's some weirdos who do it out there?

Also, 2 of the graphs are a timeframe stretching back to 1880.  (I'm not sure how they calculated S&P 500 index yields before such a thing ever existed.)  The other graph begins in 2002? 

From Wikipedia:  "Standard & Poor's introduced its first stock index in 1923. The S&P 500 index in its present form began on March 4, 1957. ...Bogle started the First Index Investment Trust on December 31, 1975."

[leostrauss]

Shiller PE has never been higher except for the dotcom bubble days. The dividend yield is interesting because it shows you how suppressed it got due to central bankers buying up long term bonds and driving prices of all yield heavy securities weighing down the yield of the SPY (by bidding up the heavy yielders).

Everything is overpriced. But hey, it is your money. Go ahead and buy, buy, buy. The big boys need the muppets. 

[Kaspian]

The big boys need the muppets.

OMFG. :/   The original point of this post wasn't whether investing is a good idea or not.  Most of us here take that as a given.

[leostrauss]

Investing is a great idea. Just at a sensible price.

[matchewed]

Keep waiting until your perfect storm to invest.

Anywho...

I view market corrections as just a result of a system that was made by humans and shows kind of an exaggerated human tendency. In aggregate and over a long term it will reflect reality more closely and the biases could be smoothed out. Over the short term it shows those human biases. Hence why people shouldn't time markets and why DCA is your best bet in your lifetime of investing.

[velocistar237]

Investing is a great idea. Just at a sensible price.

So you bought in 2009 when the Schiller P/E was at 15? When did you decide to sell?

Considering that it's only been that low once in the past 25 years, where do you keep your investments?

I can see the point of using Schiller P/E to help determine when to pull the trigger, but I don't see it as very helpful for timing the market.

[leostrauss]

Alas, I did buy Europe stocks in 2011 (didn't have any serious money in 2009). I sold it all in 2013 and 2014 when valuations were getting too crazy. Yes, too early but hey, nobody goes bankrupt taking profits.

Now I have more than sixty percent in cash and short treasuries and trickle buying some stuff that is in the doghouse namely XLE, EWA, EWC, RSX. I'd go all out on emerging markets and/or energy stocks if global market valuations were any more attractive but the overpriced global market means that I may get still better deals on the unloved stuff so I'm keeping a lot of dry powder.

And yes, I believe bogleheads are full of shit. You can time the market and sector pick if you don't lose your bottle and sell the hated stuff at a loss. I bet you all kinds of value funds are loading up on oil companies right about now.

My unsuccessful investing adventure is my TFSA where I actually listened to the bogleheads and just bought broad index funds with no attention to value being offered and I'm pretty much with the same money I deposited after almost 4 years of such 'investing' (including reinvested dividends). That's a big opportunity cost.

[forummm]

I have no idea how PE ratio makes an investor money anyway.

It's relevant to future returns. If you buy at a higher PE, then you are paying more now for the future returns. If you buy at a lower PE, then you are paying less now for the future returns. But even at the slightly overvalued PE we have now, you'll still make a lot of money if you buy today and leave it there for decades. The market could easily just have slower price increases over the years while paying out dividends as the earnings catch up to the prices. If you sit on the sidelines during that you miss out.

[Kaspian]

My unsuccessful investing adventure is my TFSA where I actually listened to the bogleheads and just bought broad index funds with no attention to value being offered and I'm pretty much with the same money I deposited after almost 4 years of such 'investing' (including reinvested dividends). That's a big opportunity cost.

I live in Canada too and don't understand this either.  Even the most conservative (70% bonds!!) diversified portfolio of index funds has done approximately: 

Annualized returns as of December 2014:

  1-year:  9.5%
  3-year:  7.4%
  5-year:  6.8%
10-year:  5.5%
20-year:  7.0%

Those aren't bad numbers.

You can check any of the mixes at CCP and they're all like that.  http://canadiancouchpotato.com/model-portfolios-2/

[leostrauss]

I had all my funds in Canadian stuff in the TFSA (due to taxes on foreign dividends). So it was XIU, ZAG, XRE, ZRR and some XDV.

As of now my TFSA is at 40,414.50 which is actually about 600 bucks less than I deposited.

[frugledoc]

leostraus you should have a nice chat with mrpercentage I think the two of you would get along very well.

[Kaspian]

I had all my funds in Canadian stuff in the TFSA (due to taxes on foreign dividends). So it was XIU, ZAG, XRE, ZRR and some XDV.

As of now my TFSA is at 40,414.50 which is actually about 600 bucks less than I deposited.

Still not sure why that isn't working if you used indexes.  Here's my TSFA.  I keep mostly bonds in my TFSA for tax reasons... With a little of some others thrown in for rebalancing.  It all looks good as of yesterday even after this year and this week's total suckage. 

[LAGuy]

Alas, I did buy Europe stocks in 2011 (didn't have any serious money in 2009). I sold it all in 2013 and 2014 when valuations were getting too crazy. Yes, too early but hey, nobody goes bankrupt taking profits.

Now I have more than sixty percent in cash and short treasuries and trickle buying some stuff that is in the doghouse namely XLE, EWA, EWC, RSX. I'd go all out on emerging markets and/or energy stocks if global market valuations were any more attractive but the overpriced global market means that I may get still better deals on the unloved stuff so I'm keeping a lot of dry powder.

And yes, I believe bogleheads are full of shit. You can time the market and sector pick if you don't lose your bottle and sell the hated stuff at a loss. I bet you all kinds of value funds are loading up on oil companies right about now.

My unsuccessful investing adventure is my TFSA where I actually listened to the bogleheads and just bought broad index funds with no attention to value being offered and I'm pretty much with the same money I deposited after almost 4 years of such 'investing' (including reinvested dividends). That's a big opportunity cost.

I've been investing for awhile now. Since well before the tech boom. There was plenty of bubble talk running up to the tech crash, but it happened WAY after all the prognosticators said it would. It wasn't until EVERYBODY was all in that the thing tanked. Including the guys such as yourself. See, that's the problem with staying out in cash. Inflation murders you, and in the meantime the doubt is eating away at you. Fear will drive you into the market high and drive you out low.

See, imagine this scenario. From here out, stocks keep powering forward at 10+% per year. Then, in 2020 there's a major crash. Stocks drop down to generational P/E lows. Ahaha! Now is Mr leostrauss's perfect investment scenario. Unfortunately, it turns out that that the 2020 generational P/E lows are still merely 2016 prices. You still ended up paying more then buying now AND you missed out on all the dividend reinvestments.

The old saw really is true: the market can stay irrational longer then you can stay solvent. Everything you may be saying is 100% right; however, you really don't have a choice but to be in the market. It's like The Game of Thrones. Win with stocks or die trying.

[Aphalite]

Leo, if you're going to use Shiller PE as a guide, you need to consider context

Shiller PE doesn't really account for interest rate/opportunity cost. Whenever it's been above 25 in previous cases, the risk free bond rate was at 5% or higher. So that means you're getting 4% stock "yield" when you buy equities whereas you can park money in bonds and get 5% - an unequal match

Right now risk free bond rate is around 2%, which you know since you're investing in short term treasuries. A P/E of 25 means stock "yield" of 4%. Is that a high enough risk premium to invest in stocks? That's honestly a question an individual can only answer for themselves. Since I can't predict WHEN interest rates will increase (and thus driving the required stock yields up and thus P/E and asset prices down), I'll continue to invest when I have the cash

Same general idea with regards to the historically low dividend yield - asset prices will move up due to lack of alternatives

[LAGuy]

Leo, if you're going to use Shiller PE as a guide, you need to consider context

Shiller PE doesn't really account for interest rate/opportunity cost. Whenever it's been above 25 in previous cases, the risk free bond rate was at 5% or higher. So that means you're getting 4% stock "yield" when you buy equities whereas you can park money in bonds and get 5% - an unequal match

Right now risk free bond rate is around 2%, which you know since you're investing in short term treasuries. A P/E of 25 means stock "yield" of 4%. Is that a high enough risk premium to invest in stocks? That's honestly a question an individual can only answer for themselves. Since I can't predict WHEN interest rates will increase (and thus driving the required stock yields up and thus P/E and asset prices down), I'll continue to invest when I have the cash

Same general idea with regards to the historically low dividend yield - asset prices will move up due to lack of alternatives

Right, in the current interest rate environment, the P/E may very well be justified. Where else you gonna put your money for yield? Higher interest rates may drive that P/E down, but who says we need a market crash to get there? Maybe the market trades sideways for years while it digests higher interest rates. Certainly, that seems to be what it has been doing this year?

Really, the worldwide headwinds facing stocks are kind of laughable compared to what we dealt with in 2000 and 2008. Low oil prices and a potential flood of cheap goods from China? Hah! I bet the American consumer is shaking in their boots! Chinese already took all of our manufacturing jobs anyways.

[leostrauss]

The headwinds facing stocks and bonds are hardly laughable compared with 2000 or 2008. Sure stocks were overpriced in those days. But at least bonds had much more room to appreciate not to mention much better coupon. These days both bonds and stocks are priced for perfection. Chances are pretty good that during the next tumble both will fall in value in tandem turning so called balanced portfolios into a bunch of turd.

[tyir]

I had all my funds in Canadian stuff in the TFSA (due to taxes on foreign dividends). So it was XIU, ZAG, XRE, ZRR and some XDV.

As of now my TFSA is at 40,414.50 which is actually about 600 bucks less than I deposited.

You shouldn't be looking at your TFSA in isolation then - Canada is poorly diversified and should only be a subset of your equity portfolio. In Canadian dollars, you should be easily up 40-60% in your US and international equities over this time period.

Even still, I don't see how you are negative if you've invested steadily for each. Just eyeballing the chart, XIU should still be up overall if you've invested every year. That's not even including dividends.

[LAGuy]

The headwinds facing stocks and bonds are hardly laughable compared with 2000 or 2008. Sure stocks were overpriced in those days. But at least bonds had much more room to appreciate not to mention much better coupon. These days both bonds and stocks are priced for perfection. Chances are pretty good that during the next tumble both will fall in value in tandem turning so called balanced portfolios into a bunch of turd.

Haha, they sure were overpriced! Not so much in 2008, but in 2000 the P/E on the NASDAQ was something like over 150! Kind of puts that S&P 500 P/E of 25 into perspective? Look, markets rarely make big moves based on their own fundamentals. The 2000 bubble is a pretty good example of just the sort of market imbalances that are required before they will make a move based on their own fundamentals. The 2008 decline and the recent China initiated decline is more how it usually happens: some external factor sends the market into decline.

And so what if bonds had more room to appreciate back then? Interest rates and bond prices go up and down. Soon, rates will probably rise and bond prices will fall. But you know what? Interest rates have gone up before. The world didn't end then. It won't end this time either. Thing is, bonds have looked like a terrible investment for a long time now. Rates are going to go up any day now! And yet, year after year. Here we are. You're short bonds? How long are you willing to wait? The Fed isn't going to raise rates now in September. Then, something will happen in the Fall and they won't raise rates in December either. Why should they? Inflation is real low. Employment seems tight, but you still have a lot of people not returning to the workforce. Then, you've got an election year. Think Fed is going to raise rates in an election year where one of the main issues is going to be the ongoing discrepancy between low wages workers and their CEO's? Yeah good luck with that. Hope you're prepared to hold that short for another year and a half at least.

See that's the problem with "contrarian" investing. Not only do you have to be right, but you have to be precise as well...you need to guess the direction of the market AND the timing. THEN, you need to get it right on the backside as well. I actually think you're 100% right about the market being pricey. But that doesn't tell me shit about what's going to happen.

[Kaspian]

...Thing is, bonds have looked like a terrible investment for a long time now. Rates are going to go up any day now! And yet, year after year. Here we are. You're short bonds? How long are you willing to wait?

Exactly!  Bond bears have been screaming, "It's gonna happen!!," for years now.  Even if interest rates go up, it's not like bonds are suddenly going to be half valued for God sakes.  I did very well around '08-'09 moving gains from bonds to equity markets. Even if bond values go down, they've done their bit very well and earned their keep in my rebalancing schema.

I actually think you're 100% right about the market being pricey. But that doesn't tell me shit about what's going to happen.

^^ And this!  ...Because the alternative is what?  Sit on cash?  Buy gold?  Real estate speculation?  (No fucking thanks.)  If the markets are overvalued (maybe), they've still done a pretty decent job for me since '11 by me annually rebalancing cream off the top into my bond allocation.