Risk-reduction driven market corrections are healthy; this one presents opportunities

screamThe pullback in the market should not be a surprise. The real surprise is the extent of the market’s ascent over the past 18-months, without a single significant draw-down. Corrections are normal during the course of a bull market, and aid in accomplishing a number of items: building the wall of worry; an important source of future buying activity, stocks stop rising which bides time; earnings and cash flow growth can catch up to stock prices, and most obviously improving valuations and avoiding bubble-like conditions.

There are a few types of corrections, all with different implications in terms of the correct response. Fortunately, for investors today, the current correction, although sure to impose short-term losses (and potentially heavy ones) is benign for longer-term oriented investors.

1) Corrections before a recession – these are the most dangerous of all as the market sells off in advance of, and during, a deterioration of business conditions. The economy contracts, sales, margins, and earnings get walloped, more so than most analysts initially contemplate, and losses are heavy, often taking years to recover. This scenario existed in 2008. There is tremendous value (in loss avoidance and/or short profits) to investors with the ability to predict this type of dynamic.

2) Corrections due to unsustainable valuations – this was the 2000 correction, which just so happened to evolve into a recession down the road. If the market is overvalued, risks are heightened because the trip from overvalued, to fairly valued, to undervalued, is a longer journey. Today’s market, at approximately 15.3x forward earnings is close to the valuation range it has been in for almost a year. This valuation range is normal based on historical context, particularly so in light of very low interest rates and inflation.

3) Corrections based on buyer fatigue and a sudden bout of risk aversion – this is what Crackerjack sees today. Optimal tactics for this environment entail reducing risk (hopefully a few days ago) for positions that become frothy or too highly valued. Then, as the pullback gains steam, getting to a point where most selling/risk reduction is no longer attractive. Eventually, when the pullback is material enough; buying decisively.

For those under-invested in tech, biotech, and growth stocks this is a welcome opportunity. For the market as a whole, CJF sees no rush to add exposures; the pullback is relatively benign and could continue. But, for select tech/biotech/growth names, 20-30% pullbacks (from highs) abound and opportunities present themselves today.

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