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Tue 20 Feb 2018 02:54 PM

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Opinion: Market corrections are part of any investment lifecycle

Stock market plunges around the world may have looked frightening, but the underlying economic picture is still positive

Opinion: Market corrections are part of any investment lifecycle
Some stocks on the S&P 500 retreated more than 20 percent from their 2017 highs by the first week of February

The panic in stock markets that we have witnessed over the last two weeks can be largely attributed to one thing: expectations of rising interest rates in major economies such as the US.

Base levels are expected to rise because inflation will increase significantly in 2018 and this is having an impact on investments across the portfolio, but the savvy investor will see opportunity where others see fright.

The start to equity markets in 2018 had been strong, but volatility – marked by daily swings on the Dow Jones Industrial Average in excess of 1,000 points – has returned to the global capital markets. The trigger to this was better than expected employment data in the US and the strong pick-up in wage growth. These have raised expectations that the pace of interest rate hikes will rise and cause treasury yields to rise faster.

Further, the US government will need to raise more funds to finance the tax reductions following President Trump’s Tax Cuts and Jobs Act, which became law in December 2017. This is also the same period when the Federal Reserve will be unwinding its balance sheet instead of buying new bonds.

Money off the table

Rising interest rates mean that there is a different asset class – namely fixed income – that is expected to provide good returns and reduce the previous high dependence on equities for growth. Further, higher bond yields reduce the attractiveness of investments in equities due to a bigger discounting factor for valuing companies. This is because higher interest rates reduce the perceived value of future corporate earnings and put pressure on profits.

Rising interest rates and inflation can also be a reflection of strong economic growth, increasing wages and more global trade”

Rising interest rates also mean that it is now more expensive to borrow money to invest in the stock markets and speculate. The era of cheap money, seen for much of the past 10 years, is therefore increasingly coming to an end. Also, when stock markets fall and there is a lot of leveraged money in the stock markets, often driven by quant funds, the fall is more severe and faster.

Passively managed funds (mainly ETFs) and by that account, funds that cost less than actively managed funds (funds run by fund managers), are the most impacted during market falls – largely due to automated transactions by these index and sector tracking funds. Therefore, in scenarios like this, investments should go into portfolios built of actively managed funds – run by fund managers who are far more capable and better at reacting to global market conditions and identifying investment opportunities.

Fund managers of these actively managed funds indeed charge higher fees than a passively managed fund, yet so much focus remains on the “cost of the fund” that investors often forget that there is a reason why actively managed funds cost more money in the first place.

Finding opportunity

On the upside, rising interest rates and inflation can also be a reflection of strong economic growth, increasing wages and more global trade. Investors need to remember that the fundamentals for global economies remain strong and corporate profits will continue to rise in the short-term and medium-term. So, the correction can be seen as a great buying opportunity for investors taking a longer-term view on quality companies, especially the ones that now have been brought down to sensible valuations.

Surely, therefore, market corrections based on these economic and fiscal sentiments should not be a reason to panic in this limited horizon.

Treading carefully

This market tantrum, though, can be seen as a starting point for events in a year or two – when the actual impact of rising inflation will be seen and all the current positive economic forces will not be able to counter the impact of tighter job markets and rising wages.

These are the times when investors must avoid panic selling – getting out of markets because they want to cut their losses”

For many investors, a correction is simply a sale. Most smart investors have been window-shopping these past few months, looking at the stock prices and then walking away – knowing that a correction is around the corner and when that correction comes, they would swoop in and buy the stocks at much better value and then hold onto them for long-term capital growth.

These are the times when investors must avoid panic selling – getting out of stock markets because they want to cut their losses. Every long-term investor during the lifecycle of their investments sees these market corrections and they are great buying opportunities always.

Some of these corrections are deep and some last a long time, testing the investor’s patience. But, as long as an investor is confident of the growth areas and has a strong rationale in those growth areas (as well as the research to back this up), there should be nothing to fret about.

I would like to end this column with a simple message: the secret to long-term wealth creation is to stay invested, wait for corrections, deploy cash, never panic and to continue to believe in one’s investments. Now that the correction has started, the investment mantra must be: “Don’t wait to invest. Instead, invest and wait”.

The plunge in numbers

The number of points the Dow Jones Industrial Average fell on Monday, February 5, its biggest one-day point drop ever.

How much the S&P 500 lost from January 26 to February 7.

This is the percentage loss in the Dow Jones Industrial Average in that same period.

This is approximately how much the stock market lost between the passing of the personal and corporate income tax cuts on December 20 and February 7.

The number of points Japan’s Nikkei 225 fell on February 6 – its steepest decline since Brexit.

The number of stocks in the S&P 500 that lost 10 percent of their value between their 2017 highs and February lows.

Vikas Sengupta, Chief Investment Officer, Guardian Wealth Management

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