If you read the occasional newspaper, watch the occasional television program, or chat with the occasional friend/colleague, you’ll have gained the impression recently that a stock market “correction” is not only likely, it’s inevitable. And “correction” means “downwards”, of course.
Let’s look at the evidence, and consider what (if anything) can and should be done.
Will the stock market crash?
- Concerns mostly center around the U.S. market, which is considered to be overvalued. By “overvalued”, I mean that one measure that determines value when buying a stock, the P/E (Price/Earnings) ratio, is significantly above 20 for the major companies that comprise the stock index there. At the time of writing, the S&P500 index P/E is around 25.
- On average, during post-war history, stock markets have seen cyclical corrections every 6 years or so. With the last correction occurring around 2008, we seem to be a few years overdue for another.
- As we saw from 2008, we live in connected times. A significant fall in any of the major stock markets tends to produce the same (irrational) contagion of mass selling in other locations, driving down prices globally. This interconnected behaviour can be seen daily in Singapore, in fact; the local market rising and falling based on sentiment in the U.S.
- Historically high company valuations may be caused by a number of factors that are either unusual or unique in recent history:
- The Quantitative Easing (“QE”) policies of central banks since 2008 have involved printing more cash, which means that there is more liquidity in the system. More demand results in higher stock prices.
- The significant growth in the use of passive index funds by retail investors due to well-publicized advantages in the cost of these is similarly fueling an increase in demand in the markets, with the same result of higher stock prices.
- Unusually low (or even negative!) interest rates being paid for fixed income instruments are making the bond market unattractive for investors, hence driving more money into stocks.
- There may be some justification for relatively high P/E ratios, supported by recently solid economic growth figures demonstrated by many of these allegedly “overvalued” companies.
So, the evidence on both sides needs to be weighed, and you, as investor, need to come to your own conclusion. What is clear though, is that the timing of any upcoming crash is not at all clear.
I’ve decided that the sky is falling, so what can I do?
So, let’s say that you’ve decided that global stock markets are indeed due a significant downward correction, “sometime” in the next 6 months. What can and should you do?
The simple solution would be to sell at what you know to be the “high”, ride out the uncertainty, and buy back at the deepest trough of the market “low”; ideally at the exact point that the markets start to recover.
Unfortunately, all empirical retrospective studies of the ability of investors to time the market in this way show that they are never successful with this simple-sounding strategy. There are two main reasons for this:
- Inability to know the future. It’s easy to be wise in retrospect and to identify the turning points in the market. It’s impossible at the time.
- Buying and selling in and out of the market incurs transaction charges, which can become significant over time.
I’ve accepted that I can’t predict the future, so what can I do?
- Diversify: ensure that your portfolio is “balanced” i.e. that it contains asset types which are negatively-correlated (since, for example, as stocks fall, bonds generally rise).
- Buy and Hold: time and again, the strategy of sticking to a well-diversified portfolio, rather than buying and selling in and out of the market, has been shown to be the best method of ensuring long-term investing success.
- Rebalance regularly: once or twice a year, take some profit off the table by selling a portion of those funds that have gone up, and buying more of those which have gone down. This discipline avoids the usual, self-destructive human behaviour of most investors who buy high (on the assumption that the rocket ship will keep rising) and sell low (on the assumption that the world has ended and they need to run for the hills).
It’s a cliché, but it’s worth concluding with the wise words that your investing journey should be a “marathon rather than a series of sprints”.
In other (wise) words, attributed to various people and relevant to many situations, not least of which is investing: “Don’t just do something, stand there!”.