Markets are Correcting? Now what?

Posted by on July 30, 2007 in Investment Strategy

As you are aware, the TSX and Dow Jones fell approximately 6% and 4% last week respectively. No one knows if this was a one-week correction or the beginning of a much larger and sustained drop in the markets.  What most people agree with is that the drop in stock prices was not seasonal in nature; there was heavy trading volumes on all exchanges last week meaning that everyone was getting out at the same time. Unlike the stock market drop earlier this year (the so-called Shanghai flu), there appears to a lot more fuel being thrown on  correction fire; the days of cheap credit are over, people are not taking as large a risk as they did last year (banks leading the financing for leveraged buy-outs are having a hard time finding other banks to participate in the financing meaning that they are assuming the entire risk of the loan) and people are running for the hills away from sub-prime mortgages (both Wells Fargo and GE have announced they will be exiting these types of loans). The big question is- now what?

First, in the words of Douglas Adams, DON’T PANIC. The markets have survived worse. The worse move that could occur is to follow the crowd and sell when the market is low. Hang tight and let’s see where the markets hang for the rest of the summer. The heavy volume may be in large part to institutions taking profits.

Second, in most corrections, the market tends to over-react and needlessly punish certain industries or stocks. For example, most real estate and real-estate related financing institutions trading in the U.S. took a beating last week- exhibit A being Brookfield Asset Management (“BAM”) (who manage commercial buildings across the global) which was trading at close to $43.00 in early July and is now trading at under $38.00 (all figures Canadian). However, its competitor, Brookfield Properties Corp., reported on Friday that its Q2 profit rose 163%. If BAM is in line with its competitor (and it reports this Friday), the market may have over-corrected on BAM and made its price attractive.

Third, you can’t hide in international equities. The London FTSE 100 and the Tokyo Nikkei 225 lost 5.62% and 4.81% respectively last week. This correction appears to be inter-linked regardless of geography.

As always, it is important to look at context- corporate earnings are slowing but from a 5 year record-breaking run so “slow” is a relative term. The other factor (which most people don’t write about) is that most non-senior level traders have not seen a slow-down or recession during their professional careers; most are in their late 20′s and were still in school during 9/11; thus, there is a natural human tendency to over-react if you have not seen the situation before.

As for me, my strategy is to sit on cash and see how interest rates will play out. If they continue to increase, the valuation of interest-sensitive stocks, such as banks and REITS, may become attractive and cash will be either used to pay down my variable mortgage more aggressively or try to consolidate stock holdings in banks.  If interest rates decrease or remain the same (which is more likely to happen in the U.S.), it may still be an opportune time to go shopping. Businesses are becoming more conservative which may mean that they will concentrate less on taking riskier ventures like lending to private equity buy-outs (are you listening TD?) and more on core steady cash flow plays.

Anyone care to share their strategies during a market correction?

1 Comment on Markets are Correcting? Now what?

By The Financial Blogger on July 31, 2007 at 6:47 am

I started investing in 2003. Therefore, this year will be my first “bad year” on the market. I kept money aside and I am definitely looking to buy more stocks if it’s starting to slide. For the stocks I already own, I do not plan on doing anything. I will watch them slide as I am confident they will come back later on. As you said, markets have the bad habit to punish all stocks, even the good one!

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