INSIDE INVESTOR: Why a correction can be good for you

Ever since the stock market took off midway through last year, there have been experts calling it a fool’s rally.

They were sceptical when the ASX200 went to 4,500. Then at Christmas they were tipping the market to peak at 4,800 by Christmas 2013.

But it powered through 5,000 in the first few weeks of the year and has continued its march northward.

Given it has run so hard and so fast, there is a big possibility we will see what is known as a “correction” pretty soon.

Stock markets never move smoothly. In this kind of market it’s a three step forward, half a step backward kind of thing. Just take a look at a graph of the stock exchange’s main index, the All Ordinaries Index, over the past 10 years, or even just the past year.

It may move in a particular direction over a long period, but there are brief interludes where it suddenly changes course before resuming its longer term trend.

In a rising market, such as we have now, a correction can be a wonderful thing for an investor looking to buy. For it delivers a brief opportunity to pick up some quality stocks at a discount.

This is where value investing, as we discussed last week, comes to the fore. That stock that had an intrinsic value of $1, that was changing hands on the market at $1.10, is now suddenly priced at just 90 cents.

The trick is how to determine whether a downturn is merely a correction, or a reversal.

Generally speaking, a correction is a market downturn that occurs simply because investors have run ahead of themselves in a rally. The pullback may be sharp but it is usually brief.

A reversal clearly is much more serious. It is usually preceded by an extended period where the economy has been strong and growth has been greater than normally would be expected.

Like an elastic band, that long period of growth can create pressures that manifest either as inflation or an unsustainable build-up in debt, such as we saw in 2007.

The global economy is still reeling from the debt crisis of 2008 and could take years to fully recover. Governments have taken on a large portion of the private debt problems of those years and now are trying to either spend their way out of trouble, as in America, or curb their spending habits, as in Europe.

No-one knows how it all will work out in the longer term. But for the short and medium term, as the risk of complete implosion recedes, asset markets such as stocks are benefitting.