Review & Outlook

Our take on the investing, financial, & economic themes of the day

The Cleansing Effects of a Market Correction

15 April, 2014 by Ben O'Brien in Commentary

From April 2 to 11 the S&P 500 fell more than 4%. In some previously high-flying pockets of the market the damage was much worse. Internet stocks and biotech stocks in particular took a hit. The NYSE Arca Biotech index dropped nearly 12% and the technology-heavy Nasdaq fell 6.9% during this period. Yesterday the slide finally stopped with a strong day after some good earnings and retail sales numbers were announced.

What do we make of the recent downturn? Not all market pullbacks are the same. This one appears to be a normal and healthy development that is, somewhat ironically, an encouraging sign for investors. The Wall Street Journal captured this counter-intuitive point in a column entitled “Stock Market Jitters Put Investors at Ease.” Why would a market pullback ever put investors at ease? A long bull market without any corrections could be a sign of exuberance that leads to a larger crash. It has been more than two years since we had a 10% correction. An occasional small pullback followed by a recovery is a healthy sign of a continued strong market. A correction flushes out the weak hands or speculators and returns investors to focusing on the fundamentals. It is also a buying opportunity.

So are we still due for a market crash now since the recent pullback failed to hit the 10% mark? While we still could have a larger downturn this year, there is evidence that we have not yet reached bubble territory. One interesting observation that we came across recently was a Gallup pole that said more Americans think putting money into the stock market is a bad idea (50%) than think it’s a good idea (46%). This compares to 67% who said it was a good idea in the late nineties when the market was actually in bubble territory. It seems that despite lasting for over five years, this is still one of the most hated bull markets in history. This kind of fear and skepticism is the opposite of the irrational exuberance that creates bubbles.

O’Brien Greene has avoided most of the highly speculative areas of the market such as social media and small biotech stocks. Now that these sectors have fallen out of favor for now, high-quality, reasonably valued stocks that we favor will likely benefit. This has already happened in technology as older, steadier companies such as  Qualcomm, EMC and Microsoft have held up nicely this year, while high fliers like LinkedIn and Twitter have crashed. The recent developments have confirmed our argument that we’ve been making for a while that certain pockets of the market were approaching bubble territory, while the market as a whole was still reasonably attractive.