Over the first five weeks of 2014, the U.S. stock market declined by roughly 5 percent. Is that a buying opportunity, or the beginning of more serious trouble?
Here are some of the issues you should think about in deciding whether to jump in, pull out or stand pat:
1. Is "correction" too nice a word?
Market commentators are discussing whether this drop in the market is the beginning of the next correction. There is actually no official definition of a correction, but it is widely believed that a 10 percent drop in the market constitutes a correction. Given that the S&P 500 climbed by about 168 percent from its low in March 2009 through the end of last year, a 10 percent correction would not be unreasonable. What you need to be concerned with is whether this is more serious than a correction, such as the beginning of a full-fledged bear market. The last bear market saw stock prices drop by more than half.
2. Beware of market timing
You can take advantage of price fluctuations by incrementally increasing your stock allocation as valuations get cheaper, and decreasing it as valuations become pricey. If instead you make a series of all-in or all-out moves depending on what you think the market will do next, you run the risk of being all wrong.
3. Price changes can be deceiving
Looking at a 5 percent drop in isolation does not tell you much. Does that drop mean stocks are now a good deal, or do you view that 5 percent drop in the context of last year's price rise of nearly 30 percent? Valuations -- the relationship between prices and the underlying company earnings or other fundamental worth -- can give you a better perspective on prices.
As of the end of January, the ratio of the S&P 500's price to its trailing 12-month operating earnings was 16.46. Over the past 25 years, this ratio has averaged 18.71 percent. This suggests that stocks are currently reasonably priced, as long as earnings continue to grow.
4. Keep an eye on interest rates
Rising interest rates create a bit of a headwind for stocks. Today's low interest rates would tend to support relatively high stock valuations, but if interest rates start to rise, it will take robust earnings growth to push stock prices higher.
5. Have you kept some powder dry?
Deciding how to alter your position depends on your starting point. Did you have some money in reserve to invest opportunistically, or were you already at the upper limit of your desired stock allocation?
6. How long can you wait to be right?
Fundamental investing means having to wait out long periods in which popular opinion drives stocks in the wrong direction. If you can wait five years for things to pan out, valuations should help you make sound decisions. If you have to be right this year, then the stock market becomes more of a guessing game than an investment.
Whatever move you decide to make, a good test is this: Is it a move you can commit to, or one you might reverse with the next 5 percent swing in the market? Volatile markets require conviction, because trying to chase the last market mood swing can be a quick way to go broke.
