The millions of new investors who have got their start in the market since March may feel a sense of infallibility to their investing careers. They’ve witnessed the greatest 50-day rally ever for the stock market, historical run-ups for stocks like Tesla (NASDAQ: TSLA), Square (NYSE:SQ), Nvidia (NASDAQ: NVDA), and Peloton (NASDAQ: PTON), the Nasdaq (NASDAQ: QQQ) index hitting new record-highs every other day, and an almost inevitable surge in their portfolios to boot. However, this behavior is unsustainable in the long run and Wall Street will soon see some form of reckoning.
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Earnings have stagnated, yet valuations soar through the roof, and while there are a number of reasons why stocks are still going up, these won’t hold up in the long-term due to the cyclical nature of the market. Throughout its history, the stock market has always brought itself back down to earth when it gets ahead of itself in the form of a correction, defined by a drop of 10% or more. For clarity: a bear market is a drop of 20%; a crash is a drop of 30%.
When stocks outpace the underlying performance of the businesses they represent, a pull-back of some sort will eventually occur. When this will happen and the severity of it is anyone’s guess, but I truly believe that there will be a reprieve from the current momentum of the market.
How do I prepare for a correction?
For many of you reading this who invest in great businesses with a long-term outlook, a sell-off should be seen as a buying opportunity. If nothing has changed about the business other than a general souring of investor sentiment across the board, it provides a fantastic chance to add to your positions in Amazon (NASDAQ: AMZN), Apple (NASDAQ: AAPL), Shopify (NYSE: SHOP), or whatever long-term buy-and-hold stocks you hold dear. A 6-month blip on a 10-year horizon is nothing.
You should identify from either the stocks you already own or those on your watchlist, the ones which have recorded the fastest recent growth. If a stock has doubled in the past three months, it is much more likely to fall significantly in a pull-back. These will be the high-growth tech stocks that have been posting jaw-dropping numbers as of late. Let’s compare the recent performance of two great businesses: Google (NASDAQ:GOOG) and Sea Limited (NYSE:SE). Since March 23rd, Google has seen a 43% increase in its stock price. In the same time period, Sea Limited has shot up by 220%. Which one is more likely to fall significantly in the next correction? While it is slightly unfair to compare a trillion-dollar company with a growth stock on the way up, it goes some ways to proving my point of what to look out for when planning for a downturn.
For those with a more short-term focus, a sell-off can have much more dire effects on one’s portfolio. The speculators and day-traders who are seeing success right now are the most likely to suffer. It’s a high risk, high reward way of investing and only the most astute traders will survive. If you’ve found yourself investing in companies for the sole reason of “they’re going up”, then now may be the opportunity to rethink your strategy. The rampant speculation that has propped companies like Nikola (NASDAQ: NKLA) and Workhorse (NASDAQ: WKHS) up won’t last, don’t get caught holding the bag when it runs out.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.
Financial Analyst at MyWallSt
Michael's first and favorite stock is Square, which he sees becoming a massive player in the payments industry and a leader in the war on cash.