Do stock markets need to correct?

Singular Vision - By Teoh Kok Lin

Past records have shown that markets can rally for long periods without any major corrections

ONE of the most frequently asked investment question in the world over the past few months is: When are we going to get the major stock market correction we have been waiting for?

Amid the doom and gloom predictions of global economic freefall and capital market disasters, the strong rebound in stock markets (worldwide but more so in emerging Asia and Latin America) since March has surprised many market participants.

Asia’s stock markets have been rallying for the past seven months without any major corrections, with the exception of a 24% and 20% drop in China’s Shanghai and Shenzhen stock markets respectively in August. Furthermore, the size of the market rallies have been pretty impressive – for stock markets such as Hong Kong, Singapore, Indonesia (up 67% to 92%), it has been the best rally since 2005.

Many view the global economy to still be in a fragile state over the past seven months, and it seems logical to say (and many did) during this period that the rally was too high, too fast. Consensus view throughout this period is that stock markets are due for a major correction in excess of 15%-20%. Yet months have passed and the global market rally still continues. Rather than follow the consensus view that markets should pullback as stocks have rallied throughout this period, we should ask ourselves two simple questions:

·Do stock markets necessarily have to correct sharply?

Past records have shown that stock markets can rally for long periods without any significant correction. In fact, the sharper the drop, the stronger the rebound; long sustained rallies are not totally unseen before. In 2003, MSCI Emerging Markets rallied 13 months while in 1987, the S&P 500 rallied for 23 months without any significant correction in excess of 10% (see chart below).

We define significant correction as a drop of more than 10% as we have seen periods where stock markets hardly experienced any significant corrections for one to two years.

We believe the values of many companies were already emerging in late September and October of 2008. The subsequent panic sell down were mostly driven by fears of a systemic meltdown of the global financial system. Since then, governments have successfully propped up the financial system.

It is not surprising that global stock markets have recovered to pre-September 2008 levels today. In other words, this rally has placed us back to where we should be.

Markets therefore are not running ahead of fundamentals and there should be more room to improve as companies and economies recover in the months ahead.

·Should we wait for a major stock market correction to buy?

It is great if one is able to time the market; sell before the market corrects and buy back at the dips and make profit. In reality, we all know that it is easier said than done.

Even if one were to know a correction is likely to occur, one may not necessarily be better off. For instance, if one purchases a share at 50 sen and then sells it at RM1.00 anticipating the market is about to correct. Subsequently the share goes up to RM1.20 and then dips to RM1.05, before recovering back to RM 1.20. In this scenario, is one really better off?

Market timing abilities and transaction cost is one part of the story. Equally important, even if broad market corrections are expected, individual stocks may be affected differently.

In the case of good companies, share price behavior may not be so dependent of the broad market, even if a correction does eventually occur. Companies such as Tencent, a China Internet company listed in Hong Kong and Indocement, one of the largest cement producers in Indonesia, are good examples of strong fundamental companies doing well despite broad market movements.

Rather than trying to second guess when the market correction is coming and how deep the correction will be, we find it easier to identify and stay invested in companies that are still undervalued and benefiting from the global recovery.

Finding good value companies to invest in however involves a lot of persistent leg work, research and company visits. But then again, isn’t that the challenge for value investors?