Opinion: Investor psychologies waffle during market corrections

In the 38 years I have been in the investment business, my research shows that I have gone through 18 corrections of 5 percent or more. This current market stumble makes it 19.

Sure, they have to happen, but the timing isn’t predictable. Evidence generally builds when the market is ripe for at least a 5 percent correction within the context of a bull market. To illustrate, this column in early June stated that a correction could occur. At that time the Dow Jones industrial average was at 13,756, a couple of hundred points shy of the much celebrated 14,000 level. Of course, the evidence is always crystal clear after the correction takes place, when the media pundits will tell us why it happened.

Investor psychology during correction times is interesting. Generally, little more than negative sentiment feeds on itself, growing erratically until a point at which, for little apparent reason, it begins shifting. It can, and often does, begin and end with what may appear to be irrelevant news.

Mind games

Psychology hits market participants in various ways.

Some, often those experiencing a correction for the first time, employ the counterproductive knee-jerk method, selling in a panic and unlikely to return to buying until the market is at much higher levels. This method flies in the face of the “buy low and sell high” maxim.

Then, there are those who sell with the idea of calling the bottom of the correction and loading up on the issues that will be the best performers in the following months. Sometimes, they even guess right by doing so before the correction. The “never try to catch a falling knife” axiom applies to this group.

Disciplined investors see a correction as an opportunity to acquire or add to high-quality holdings. They are the long-term winners. They don’t simply buy stocks; they see their holdings as passive ownership in good businesses. Those investors may be focused on dividend growth rates or free cash flow or any number of metrics. They are the ones who may not accumulate the wealth of a Warren Buffett, but they are likely to be very successful by emulating his style.

Correction vs. bear market

So, is it a correction or the beginning of a bear market? Our bias is that it is a correction.

If it is the beginning of a bear market, then the market as a discounting mechanism is telling us that the current positive economic conditions are going to change. Slow but steady growth of gross domestic product must decelerate, historically low unemployment rates must rise, consumers must sharply curtail spending, and corporate earnings must decline.

So far none of this has materialized, and no trends indicate that there is likely to be a seriously damaged economy or a bear market. It remains to be seen if this correction is one that is normal within the context of a bull market.

There is an investor subset that ignores all of this correction versus bear market discussion. They are the ones who are in the strange reasoning category that includes those who won’t sell because they don’t want to pay taxes, their stock was inherited from Aunt Bea, or it wouldn’t be right because that was where they worked. We’ll address these and other such foibles in a future column.

Disciplined investors

What to do now if you are a disciplined investor?

Of the various metrics listed above, let’s look at one – stocks with solid dividends. Compare the dividends and dividend growth rates of the large companies to the 10-year Treasury, then ask yourself which you would rather own for the next 10 years: the Treasury yielding 4.7 percent or one or more companies that have comparable dividend yields and are likely to increase those dividends regularly. Among the list, you will find Wachovia (4.8 percent), Citigroup (4.6 percent) and Bank of America (5.4 percent). Yes, they are all in the currently much-maligned financial industry, and are all under pressure in this trampoline market. But are they likely to be in business 10 years from now and paying a higher dividend? We think so (and may be buying these issues on behalf of our clients or for our own accounts), making this one of those opportunities for the disciplined investor to add to or acquire solid companies.

Clark Davis is a 38-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.[[In-content Ad]]