By Eric Weigel

It's been a trying time for equity investors, with tremendous volatility these past weeks, stretching all the way back to a pretty significant correction in the fourth quarter of 2018.

High equity valuations, an inverted yield curve, a profits slowdown, tariff wars, and the endless chatter coming from Washington have all made investors skittish. And now, investors are worried about the global economic impact of the recent coronavirus outbreak.

After a long period of minimal equity market hiccups, investors have been reminded that the opposite side of the return coin involves risk. Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.

The key insight from looking at the history of stock market returns is that to get the good returns (those averaging 10% a year), you must be prepared financially, and most importantly emotionally, to endure the bad (those nasty corrections).

Investors need to remember that risk and return are the opposite side of the same coin. They also need to understand the context in which market corrections take place. While history always rhymes, every equity market correction possesses unique elements that shape its ultimate effect on investors.

Understanding the market and economic context is very important for everyday investing. It is, however, absolutely critical for understanding the implications of equity market corrections and the most appropriate course of action.

Not all equity market corrections are made of the same cloth. Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.

The lingering suspicion over the past year is that this party (the bull market of the past decade), like all others before it, must end at some time. Maybe it's just time, right?

While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections: technical, economic, and structural. Each type of correction has its own distinct patterns and associated implications for investors.

Technical correction: This typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into two or three in a row and soon enough, there is an avalanche of pundits predicting the next global crisis.

Those pundits use perfectly logical arguments to justify their bearishness: Inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.

These are all perfectly valid reasons for an equity market correction, but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.

Technical corrections tend to occur on a regular basis especially for higher risk asset classes such as equities. Long-term equity investors have seen these before and do not seem fazed by the market action. Newer generations of investors, however, experience great fear and regret. The immediate response is to sell down, usually their most liquid holdings, and wait for the market to calm down. Maybe they will get in again after the panic is over.

Technical corrections tend to last only about a week or two. In the context of long-term capital market history they barely register to the naked eye. Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.

Economic corrections: These are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery. Typically, the clues as to whether the economy is heading into a recession are present ahead of time.

Usually, a large number of economic indicators will point in the same direction. For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment, and layoffs start accelerating in cyclically sensitive sectors.

In the past half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are painful but the implications to investors are fairly straightforward.

In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside. As the economy starts recovering, equity investments outperform marginally but with significant volatility.

Being early is never comfortable but it beats being late. Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake-bitten to put any money at risk.

And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds. As the uncertainty regarding the economic recovery fades, capital markets tend to become less volatile as well.

Structural corrections: These are the most severe type and involve periods of real economic and financial stress. Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.

Structural corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake. Without decisive fiscal and monetary policies there is a risk of total economic collapse. Under these circumstances, equity investors are often completely wiped out and bond holders don't fare much better.

Structural corrections happen during periods of total economic unraveling. The most usual signs of imminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost. The financial system is usually the root cause of the crisis and liquidity in the system suddenly disappears. Faith in the system dries up overnight -- the first stop are the banks, next are capital markets.

The Great Depression of 1929-1939 and the financial crisis of 2007-2009 are prime examples of structural corrections that were felt across the globe. History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.

What should investors do during a market correction?
The answer depends on the context surrounding the capital markets at that moment. For example, the implications of a technical correction are very different from those of a structural correction.

Misdiagnosing what type of correction you are in can have severe consequences for your financial health. Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.

Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything. In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.

Here is a checklist of the type of issues that we consider when evaluating the type of correction we might be in.

Measure

Technical

Economic

Structural

Frequency

Often

Once every 5 or 6 years

Every 20 or 30 years

Duration

1 or 2 weeks

6-12 months

Years

Severity

Mild

Medium

Severe

Warning signs

Exuberant expectations, disregard for risk, long running bull market

Deteriorating economic growth, loss of confidence, inverted yield curve

Unsustainable increases in leverage, nonsensical business practices

Short-term response

Nothing. Stay calm.

Lighten up on equities

Sell public market securities.

Tactical response

Deploy cash if available, buy market leaders

Invest in value stocks ahead of the full recovery

Buy distressed private assets and gold, stay liquid

Recent instances

Feb. 2018, Aug. 2011, Jan. 2016

March 2001 - Nov 2001

Dec. 2007 - June 2009

About the author: Eric J. Weigel is the founder of Retire With Possibilities, a coaching and planning business focused on key retirement issues. He is also an investment adviser with Little House Capital, an SEC-registered firm based in Massachusetts, with more than 30 years of experience. He is a certified professional retirement coach and an MBA graduate from the Booth School of Business at the University of Chicago.