The Dreaded Correction

Financial markets have been experiencing heightened volatility recently, with some of the biggest swings coming on the heels of the Federal Reserve’s statements on June 19th.  Events like this become a virtual feeding frenzy for financial news media, and represent one of the crucial moments in which many bad decisions can be made via lost perspective.  I believe it’s essential to step back, gain some context and decipher what everything really means and how it affects you.

Here’s what’s going on:

You’ve likely heard the term Quantitative Easing of recent.  This multiple-phase bond buying program by the Federal Reserve (“the Fed”) has intended to support the economy in the slow growth environment we are in.  This seems to have worked, as markets have continually risen higher.  However, a few weeks ago the Fed began to hint at the probability of “tapering” back their stimulus program as long as the economy continues to go in the right direction, albeit slowly.  The market did not react well to this news at all and stocks began to retreat, with some stocks in the Real Estate and Utilities sectors posting double digit losses in a short period of time.  Bonds also got hurt as we saw interest rates begin to increase slightly.

Over the past several weeks investors have been waiting for the next clues from the Fed as to how long we can expect the stimulus to continue, as if it’s a drug that the markets need to survive and if taken away stocks will begin to suffer in withdrawal.  Well, the most recent clues came on Wednesday in the form of a Fed statement and Ben Bernake’s subsequent remarks.  The gist of these statements were that the Fed continues to look for the most reasonable way to begin tapering the stimulus program without causing shock to the markets, and the general tone was that they would continue to gradually slow down their support of the economy in the coming months as long as economic growth appeared positive.  With this, markets sold off again in fear of discontinued stimulus, even though the reason for the tapering is continued optimism that our economy is going in the right direction and will be able to sustain itself without Fed intervention.

So, should you be concerned about these recent events?  Depends on what you’re investing for, but for most people the answer is probably no.  For anyone with any semblance of a time horizon (5, 10, 15 years or more), I don’t think it’s really that significant at all.  You have to understand, as Morgan Housel perfectly illustrates here, that a lot of the “action” in the markets stems from trading done by entities and institutions (and High Frequency Traders) that do not possess the luxury of a time horizon.  Their performance is measured in days, weeks and months.  So, whether or not an asset has significant appreciation potential over the next several years often means nothing to a trader, while it means the world to an investor.  Trading behavior can negatively affect a stock in the short term regardless of that stocks long term prospects.  This is why it’s so important to see the big picture and not get caught up in the day to day trading activity.  Too often the action in a day of trading gets translated into talking points directed at investors, filling individual investors with doubt which threatens to derail their long term objectives.

It is important to understand where we are in context of where we have been, but it’s foolish to make “actionable” forecasts as to where we are going in the short term.  Whether or not and when the Fed will begin to taper is a short term forecast and acting on it is not likely to help the cause of long term investor with a well-designed portfolio.  A larger issue that many seem to miss is that there is an assumed correlation between markets and the economy, though this might not be the case, as Barry Ritholtz states:

“As to the markets, I hope you realize they are separate and apart from the economy. The data overwhelmingly shows that most of the time, stocks and the economy are wholly uncorrelated. Over the short and medium term (days weeks months), there is almost no relationship in either direction or magnitude. People often have difficulty accepting that, but the academic studies on it are overwhelming. Over the longer haul (decades), there is some correlation between GDP growth (3-4%) and corporate earnings (6%), and I assume they are not coincidental. But that is only over long periods of time, and even then they can become somewhat disconnected.

During volatile markets, it’s essential to identify and separate the factors which are driving the volatility from the factors that drive your investment decisions.   As long as your investment decisions are driven by a genuine process, built on a solid foundation and the big picture fundamentals remain encouraging, then be careful not to let short term actions by other market participants make you doubt the merit of your decisions.

Reed Bermingham is a financial advisor located at Manning Wealth Management: 2550 Fifth Avenue, Suite 800 San Diego, CA 92103. He is a registered representative and investment adviser representative of and offers securities through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. He also offers advisory services as an investment adviser representative of Manning Wealth Management, Inc., ad Registered Investment Adviser, which are separate and unrelated to Commonwealth. He can be reached at 619.237.9977 or at reed@manningwm.com

Sources:

Your Last Remaining Wall Street Edge
Morgan Housel
The Motley Fool
June 18th, 2013

“What’s your outlook on the markets and the economy”
Barry Ritholtz
The Big Picture
June 18th, 2013

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Categories: Economy, Markets

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