Slowly, or all at once
Stock market corrections are never pleasant for anyone. However, they are a fact of life and an investor always needs to be mentally prepared when they arrive. Stepping back from the noise of the media, we would like to share some of our observations in this regard.
Corrections are important for the health of the overall market since they shake out weak or nervous investors, leaving shares in stronger hands. We note that the markets had risen for over a year without a significant sell-off, and having one now is not unusual.
Stepping back and understanding the current dynamics in the market, it is not hard to see why the correction happened now. Interest rates have been rising, which while a good sign, does affect the stock market. We expect stocks to adjust to this, but also believe that several other factors are involved that exacerbated the sell-off.
We have written many times about the immense popularity of passive investing, the extensive use of algorithms (computers) and the rise of trend following strategies, all of which lend themselves to high downside volatility.
Passive investing through ETFs allows investors to easily enter and exit the market, so when the market looks bad to them they can sell with one click of the button.
Algorithms simply follow rules they are programmed with and will sell when certain criteria are met.
Trend following strategies are used by algorithms and passive investors, but they also include groups of speculators that trade stock market futures. When the trend turns against them, they sell immediately.
Corrections happen one of two ways, slowly, or all at once. Due to the factors listed above, it appears at this point that the sell-off that began last week will be of the "all at once" variety, sharp and relatively short lived.