Nine days ago, after a series of sharp sell-offs, the Standard & Poor's 500 index was down 7.4 per cent from its September record as fears of a global economic slowdown intensified. Stocks have surged back this week, thanks to strong corporate earnings, and on Friday the S&P 500 had its best gain in nearly two years.
How should investors view this intense flip-flop? As an overdue reminder that stocks aren't a one-way ride up.
While last week's slump doesn't technically count as a correction, defined as a 10-per cent drop from a peak, that's how many professional investors view it.
"It's important to have these periods of scare and fear,'' says Joe Quinlan, chief market strategist for US Trust. "It keeps investors honest and it keeps them on their toes.''
In fact, such sell-offs often provide a base for another move higher in stocks, market observers say.
That's because a slump stops people from focusing on the upward momentum of the stock market. If prices rise with few bumps along the way, investors sometimes stop considering the fundamental drivers of the market, such as company earnings and the health of the economy, Quinlan says. Investors are also tempted to ignore a tenet of investing: Diversify. After a big drop, though, they think about putting money into other things besides stocks.
It has been more than three years since the last correction and that was making some investors hesitant to buy stocks. The average amount of time between slumps is 18 months, according to data from S&P Capital IQ. Many investors reasoned that, statistically speaking, at least, the market was due for a sell-off.
John Manley, chief equity strategist at Wells Fargo Funds Management says that the recent plunge wasn't typical of a sell-off that precedes a deeper drop in stock prices.
Instead, the slump was typical of a sell-off that happens in a rising market, known as a bull market, he says.
By contrast, declines of 20 per cent or more, known as bear markets, tend to start with gradual sell-offs, rather than sudden swoons, Manley says.
"The thing about bull market corrections is that they come out of nowhere, and they are very violent and they are very nasty, and they are very short," Manley says.
For a deeper sell-off to happen, investors need to become complacent, or wildly enthusiastic, he says. So far, he sees little evidence of that on Wall Street. Manley expects the stock market to continue to stabilize as the US economy strengthens and company earnings improve.
Some believe that the slump changed the psychology of the market. The Chicago Board Options Exchange's volatility index, known as the VIX, or fear index, rose as high as 31 during the day on Oct. 15, but has since fallen back to 16.11. The yield on the 10-year Treasury note fell as low as 1.91 per cent last week as investors snapped up safer government bonds. It now trades at 2.27 per cent.
But Brad McMillan, chief investment officer at Commonwealth financial network, an independent broker dealer, sees more caution in the market.
The sharp sell-off has made investors focus on risks, such as a slowdown in growth in Europe and China.
"There are cracks in the ice at this point," said McMillan. "People are really starting to process the fact that 'we're pretty far up there,'" in terms of stock prices.
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