Corrective Measures

Our daddies told us there'd be days like this. The S&P 500 took a whooping to the tune of nearly 2.7% today, capping what's been a tumultuous couple weeks in the market.

Maybe volatility has finally returned to markets. Maybe. Then again, weren't we all asking this same question just a little over a year ago? It seems folks have short memories. May 2006 was not a good month for stocks. Global markets were consistently trounced, leading to the first true correction of this bull market.

But the correction passed, and 2006 ended up being a good year for stocks. Today is, in our minds, a classic example of a corrective phase in the markets and not the onset of a new bear market. How can we know the difference between a correction and a bear? Let's first define a correction:

1. It's short. Corrections don't usually last very long. Most of the time they linger six weeks to a couple months. May 2006's correction was only about five weeks long, in fact.

2. It's sharp and steep. Corrections happen quickly, generally with pretty heavy downside volatility. Bear markets usually roll over and generally lull investors to sleep. As the last bear market began, the S&P 500 only fell about 11% in nine months. A bear market doesn't usually announce itself as such. Corrections, by contrast, are pretty hard to ignore.

3. It's scary. Big downside volatility associated with a correction is very scary—it shakes that positive sentiment right out of the market. Just a couple weeks ago we were reading headlines about new highs in consumer and investor confidence. Ha! We doubt that'll be the case on the next report. This is a good thing—we like to say bull markets climb a "wall of worry." Corrections and sharp drops are fertile territory for renewing worries.

4. It's emotion based. We dare you to go through today's financial stories and count the number of times the word "worries" or "fears" pops up. It's truly amazing. But as we've outlined in past MarketMinder commentaries, the fundamentals haven't materially changed. It's still a great economy with benign circumstances for continued robust activity. And by the way, stocks are still very cheap.

Each correction is a bit different than the last, and history never exactly repeats itself. Who knows what will happen from here. But it should be at least clear what we have today are not typical features of a new bear market. For a true, roaring bear, you need something big and bad and fundamental folks aren't recognizing—that is, something that isn't already reflected in stock prices.

See these past commentaries and columns for more on our thoughts about the last couple weeks:

• Column: "Into Perspective: A Passing Storm," by David Eckerly (8/2)
• Commentary: "The (Credit) Party We Weren't Invited To" (7/27)
• Commentary: "Debt Disambiguation" (7/26)

Stock investing can be a rollercoaster, and you've got to have the stomach for it. The last several years have been a period of unusually low volatility. Volatility doesn't actually tell you anything about the direction of the market. You can have good volatility and bad volatility. (Most folks don't complain too much though when we see the big upside volatility.)

We often like to say that, ultimately, investing is a discipline. This is an important time to maintain focus and stick to your guns. Because what many fail to recognize is that corrections can end as quickly as they started. Trying to navigate a correction is a bad idea. They're too short, and there's a great chance you could make a mistake.

Whether this downside volatility continues for a bit from here or not doesn't much matter. Today stocks are undervalued and the solid global economy isn't being appreciated by investors. Instead, we've got fears about subprime and credit crunches that aren't nearly as bad, nor as big, as the financial press is making them out to be.

Put in different words, this is an opportunity, not a time for fear. Sit tight, and enjoy the weekend.