The phrase “healthy correction” is one of the most frequently used in the investment lexicon. It has been ubiquitous over the past few days as a descriptor of the significant falls in global markets.
It is also a phrase that has puzzled me over the years.
As to “healthy”? Falls of over 4% in a day – with intra-day moves of twice that- did not feel “healthy”. Neither did what looked and felt like computer-generated trading, exacerbated by forced selling. No, all this felt distinctly unhealthy.
My first experience of the word “correction” was at school. A correction on the page of your jotter meant you had got something wrong. Of course, this is not the definition most users of the word are employing this week. Rather, they are thinking that “someone else got it wrong”.
So how should we reflect on a rather eventful week?
First, we should remember that this week’s declines have taken many markets back to roughly where they started the year. This is not a disaster, given the rises that we have enjoyed in recent years. But the flip side of this observation is that there are healthy profits still to be had in most risk assets.
We have seen a steady rise in bond yields this year on the back of rising interest rates, stronger growth and inflation and an expectation that the liquidity tide of quantitative easing is on the verge of ebbing. This is not a surprise; it has been widely flagged, and is expected by most. As US bond yields headed towards 3%, the debate escalated as to what level of risk-free return would start to compete with the returns available from riskier assets. This week’s market movements appear to suggest that we may have reached a level at which that debate will intensify.
Economies are not the same as stock markets
This week reminds us that economies are not the same as stock markets. We are in the midst of a period of synchronised global growth. The economic outlook is much rosier than most would have expected just a few quarters ago. Most investors would now share this rosy outlook – but strong economies do not necessarily mean strong stock markets.
Investors should be reassured by the strength of company profits.
This said, investors should be reassured by the strength of company profits, and by the dividends and share buybacks facilitated by high corporate cashflows. US earnings have been particularly strong, and expectations for tax cuts have boosted estimates for this year and beyond. Inflation is likely to edge higher, but we do not expect it to surge dramatically as structural headwinds remain significant. Accordingly, central banks are unlikely to be aggressive.
The selloff is also a reminder, if any were needed, that risk assets are certainly no longer cheap and are hence vulnerable to these so-called “healthy corrections”. This market move serves to remind investors to be wary of high valuations, to be wary of high leverage and to value quality. It should encourage them towards diversified portfolios and assets that can survive the “bumps in the road” that we can see. And, more importantly, the “bumps in the road” that we cannot.
The article above previously appeared on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 9th February 2018