Questions and Answers About Market Corrections

The start of 2018 has focussed attention on a number of issues, including the strength of the world economy, triggering a debate about whether inflation could return. Alongside this, markets have become concerned about how much monetary policy might be tightened this year.

One consequence has been heightened attention on whether equity markets are due a major correction. In the wake of events at the end of last week, when US bond yields rose and equity markets fell – both in the US and internationally – we feel it is an appropriate time to provide answers to questions around market corrections. (For more detailed suggestions about what to do – or not do – in a downturn, you may refer to this article we wrote in December.)

1. What is a market correction?

A correction is when a market is expensive and falls to correct the overvaluation. Although a correction is most likely when prices are too high it is also possible for markets to correct when there is an unexpected event (say an election) or bad news (say a terrorist attack or geopolitical incident).

As financial markets can be volatile and thus move up and down on a frequent basis, a correction usually refers to a significant move – but there is no hard or fast rule on what constitutes a big move. It is tempting to say you know it when you see it, a bit like a volcanic eruption, it is big enough to be noticed. Some might call a correction a move of 10% or more from peak to trough – and this has often been seen as the benchmark to be called a correction. In recent years, volatility in markets has been low, but this is set to change this year.

2. Does a correction mean a market will keep falling?

No. It depends upon the trigger, overall environment and outlook. Financial markets can experience long periods when their trend is up or down, occasionally sideways. This is true for currencies, shares or bonds, and other financial instruments. Sometimes a correction can be a precursor to a sell off. Other times, a correction may provide a buying opportunity.

If a sell off continues for a long time then – in the case of equities – it is thought of as a “bear market” where the direction of the market is in a downward direction. In a bear market for equities, economic news is often interpreted in a negative way. In contrast, a bull market is a rising market.

There is a need to differentiate between a correction that occurs in response to a specific event (say, equities falling after the referendum result) versus one that is an attempt to correct the pricing of an asset, moving it to a new, lower level.

Whatever the trigger, the outcome is a reassessment of what lies ahead and an attempt to achieve a better valuation. At turning points, markets can become more volatile, and thus a large fall one day could be followed by large moves both up and down in subsequent days or weeks, before a trend becomes clear.

3. Can you give some idea of how often these occur?

Let’s use the FTSE 250 as an example. This is the UK stock market covering the largest 250 firms outside the FTSE 100, and so is representative of economic and financial developments here at home and overseas and how they impact UK listed companies. Since its birth a quarter of a century ago, its largest daily rise was 7.75% on 19/9/2008 and its largest daily fall was 7.19% on 24/6/2016.

Based on consecutive quarterly returns, its longest rally was up 113.1% from 2003 (Q2) to 2006 (Q1). The longest losing streak stretched over seven consecutive quarters from 2007 (Q2) to 2008 (Q4) and saw a fall of 42.21%.

4. So markets correct on a regular basis?

Yes. Perhaps this table using monthly data from 2008-2017 can help. The first column shows the extent of the fall and the next columns show how often this degree of fall was seen in that particular market over that period.

Correction Size FTSE 100 FTSE 250 UK 7-10 Year Gilt Index
10% 6 3 0
5% 10 10 1
3% 16 16 4

Source: Bloomberg

5. Why is this a good time to be aware of this issue?

In recent years, financial markets, both in the UK and overseas, have experienced a relatively favourable backdrop. The main reason for this has been a combination of improving economic news (admittedly it has varied by country), and accommodative monetary policies, including low interest rates. The result has been ample liquidity that has needed to find a home somewhere – and financial markets have been a prominent beneficiary.

In fact, since the 2008 global financial crisis, nine years of cheap money policies in the UK and most western economies have benefitted financial assets, including bond and stock markets. Now, this cheap money policy is in the early stages of being reversed, led by the US Federal Reserve, which has been raising rates for over two years. The Bank of England, meanwhile, hiked rates at the end of last year. Although it should take some time, the key issue is that the reversal of monetary easing could expose the current high valuation of financial markets and lead to a market correction.

6. Can we predict market corrections?

No, although it is possible to anticipate them. Markets can sometimes look overvalued based on a range of criteria. The challenge in predicting a correction is that if markets are overvalued they can overshoot and become even more overvalued before they correct. There is no evidence of active fund managers being able to predict a market correction on a sustained basis. We will cover this in a forthcoming note.

7. Whenever we hear of a market correction or a market crash it is always in relation to stock markets. Does that mean bond markets do not correct or crash?

No. A market correction can occur in any market. In currency markets we do not refer to it as a correction – a sharp fall there is referred to as a devaluation. In bond markets there can also be significant corrections. In fact, now is a good time to be aware of this. Since the late 1980s the UK government bond (gilt) market has enjoyed a sustained rally, with a long-term fall in yields. This bull market for gilts has, naturally, seen significant market corrections along the way. These are seen in terms of yields rising, as that is the equivalent of gilt prices falling. Now, yields are low but rising as official interest rates increase.

8. What caused equity markets to fall last week?

A combination of factors happened. In recent months economic data has been strong, feeding fears that monetary policy could be tightened faster than markets have been expecting. Last week, an upbeat economic message from the US Fed and faster growth in US wages than expected fed worries that inflation and interest rates could rise more than anticipated.

The most significant development was that this fed a rise in US bond yields. By the end of the week they had risen to 2.85%, versus 2.41% at the start of the year and 2.16% at the beginning of September. This backdrop led the main US stock market, the S&P 500 to fall 3.85% last week. This sell-off followed a prolonged rise, so the market was still up 3.44% since the start of the year. Likewise, the FTSE 100 fell 2.9% last week, leaving it down 3.1% since the start of the year. The strength of sterling has been a key factor contributing to the recent underperformance of the UK market.

9. Is it possible for all asset classes to sell off together?

Yes, but it is not that common, hence the benefits of a diversified portfolio. Sometimes investors have a preference to be invested more in one type of asset versus another (say equities over bonds) as that fits their personal needs and expectation of the future. One can look at the correlation between different asset classes to get an idea of how they have moved together.

10. Does Brexit make UK assets more or less vulnerable in difficult times?

Brexit creates uncertainty during the exit process, as we are seeing, but once exit has occurred then the greater clarity should allow a firmer assessment to be possible. UK assets need to take into account not only the outlook but also recognise that the UK authorities have policy tools such as interest rates that can be used to stabilise the economy if needed, and thus impact the markets. Sterling, too, can be flexible.

11. Could UK interest rates fall if financial markets hit difficultly?

Yes, but we are not expecting rates to be cut. The Bank of England raised rates recently but they have taken into account different risks in making their decision. While they seem unlikely to cut rates they could always do so if there was a shock. Indeed at the IMF meetings last October in Washington one view among global central bankers was that they needed to raise rates soon so they could cut rates in a few years if economic conditions deteriorated. That being said, our view is that the Bank will rise rates twice this year, in two quarter point moves.

12. As manager of my investment portfolio, what asset allocation steps are you likely to take in the event of a bear market?

Our investment approach is to try and mitigate prolonged periods of volatility by a strategic diversification across asset classes, regions and currencies. Centralised management brings considerable benefits. We also implement cyclical adjustments to portfolios with the aim of addressing specific economic concerns or market risks that may knock performance off-track.

13. What is the key takeaway from this article?

There can always be corrections. We should not be shocked if they happen or panic if they do. Clients should aim to choose the risk portfolio that best suits their needs and allows them to feel comfortable withstanding market corrections as and when they occur, rather than attempting to time the market, which evidence shows is incredibly difficult.

As always, we encourage clients and potential clients to contact us at any time if they are unsure of anything to do with their investments, would like more guidance or would like advice specific to their circumstances.

Please remember that when investing your capital is at risk.

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