Asset bubbles are rarely recognized by those inside them. But when the market correction materializes, the story is typically easy to relate.  In March 2000, for example, when the bubble burst it didn’t take long to understand that valuation metrics based on customers per click or “eyeballs” really weren’t enough to justify such lofty stock prices. No, a 107 Price-to-Earnings ratio (or, PE Ratio that is a time tested metric that, at 107, was showing an inflated stock market) in the Nasdaq stock index was, in retrospect, a simple rationalization for the precipitous drop in equity prices.  Or, in September 2008, when the credit bubble burst and investors figured out CDOs, “liar loans”, and bank balance sheets stuffed with worthless assets that were levered up 35-to-1, the subsequent run on the banks and stock market meltdown was easily validated.

But this is not 2000. Arguably, asset prices in certain areas of the market such as biotech, private equity and social media are frothy, however, the major stock indexes have reasonable valuations—which are rich, for sure, but still reasonable.  This is also not 2008. Domestically, we are not involved in a credit crisis.  Of equal importance there is little bank “counterparty” risk (the risk that banks won’t get paid back by other entities for loans made) so our entire payment system is not gummed up as it was in 2008.  Sure, there are real concerns.  But in past violent stock market corrections, the flashing red signals were smack dab in front of us upon the market’s decimation.

In this context, former chief economist of the International Monetary Fund, Olivier Blanchard states, “The stock market movements of the last two weeks are puzzling.” (I urge you to click here on this link and read Mr. Blanchard’s full article)  Mr. Blanchard disassembles the major concerns for global financial markets:  namely, China and oil prices (for a further bullish opinion on China’s significance on global markets, click here: Alan Blinder WSJ 01.20.2016).   Blanchard then goes on to offer his favored explanation for the selloff, which basically states that money manager are acting based upon some “herd” mentality by selling assets based on nothing more than “uncertainty”.  The implication is that there is no fundamental reason whatsoever, but just due to the fear of the unknown—“political uncertainty at home and geopolitical uncertainty abroad are both high.  The Fed has entered a new regime [basically impotent at this point].  The ability of the Chinese government to control its economy is in question.  In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fear mongers to gain popularity.”

Although we can’t explain the market’s recent sell off with the exact precision of past sell offs, the theme of “uncertainty” is common to all major market routs.  When the internet bubble burst we knew the why but we didn’t know how far (the PE ratio shouldn’t, or couldn’t, have rationally been set at 107, but it should have been reduced by precisely what amount?).  In 2008, we knew the banks were in trouble, but their mere survival was in question leaving us uncertain as to the appropriate market valuation in a world that might not have major commercial banks.  What we should not dismiss in today’s market then is the emotion/human psychology of the fear of the unknown that drives investors to hit the sell button.

Some of the greatest investors of our time have asserted that the market is not always efficient.  George Soros, William O’Neil and even Eugene Fama himself have dismissed the idea of market efficiency in one way or another.  Soros’ theory of “reflexivity” is a commentary on the human capacity to change events by taking actions ahead of perceived expectations (that are inherently flawed) only to distort the outcomes expected in the first place.  So, for example, the expectation that slower Chinese growth will lead to lower stock prices—no matter if the premise is inherently flawed or not—can lead to lower stock prices.  In other words, lower stock prices beget lower stock prices.  It only takes this perception.

So, what is the strategy?  As Ron Lieber wrote in the NY Times, “Plenty of research shows that if you miss just a few days of the market’s biggest gains, your long-term portfolio will suffer badly.  If you decide to put a lot of your money in cash right now, how will you know when to get back in the market?  You’ll probably be looking for a sign, and that sign will be the rebound days on which you missed out.”

I agree.  It’s not time to panic.  Remember, corrections are normal.  “It would take decades of systemic economic erosion to prove otherwise, and a few weeks of market declines do not suggest that anything like that is upon us,” says Lieber.  Each year the stock market has averaged one 10% correction per year.  We are now down approximately 9% in the S&P in the first few weeks of January alone, while down close to 12% from a November 2015 high.  A brutal selloff, for sure.  But as I don’t recommend going to all cash, some paring back of positions to become more defensive (for accounts that were more aggressively positioned) is a strategy that has been in order.  Historically, half of these 10% corrections turn into 20%+ corrections.  If and when stocks break through to the downside to the next level of support (1823ish on the S&Ps) it will be time to become even more defensive as the odds of a recession will increase (the idea of reflexivity where stock market declines impact the economy).

The next few weeks are critical. As Blanchard writes, “If it becomes clear within a few days or a few weeks that fundamentals are in fact not so bad, stock prices will recover, just as they did last summer, and this will be seen as a hiccup. If, however, the stock market slump lasts longer or gets worse, it can become self-fulfilling.”

As always, please call or write with any questions or concerns.