Stock market corrections, when reality hits home

The recent volatility in worldwide stock markets seems to have “taken many by surprise” (one of many Stock market corrections over the years). Despite the fact there have been warnings from months it seems the reality of recent issues impacting the worldwide economy are only hitting home now. Human nature is in very predictable thing; we take markets to record highs on the back of overexuberance and then crash them to levels which are oversold on fear. So, what has been on the cards for many months now but been ignored by so many investors?

Base rates

Base rates around the world are still near record lows despite the fact that the worldwide recession which caused the collapse of base rates occurred more than a decade ago. Talk of an improvement in economic activity over the last decade has to a great extent been based upon cheap finance. This is the type of finance which cannot go on forever and will eventually need to be repaid. The latest concerns regarding economic growth in the US and around the world may delay any further short-term increases in base rates but they will still maintain their upward trajectory.

Wage inflation

This is perhaps one of the most alarming concerns when it comes to investors jumping on the bandwagon. History shows us that time and time again wage inflation will lag sales growth and increased corporate profitability. So, as we are seeing at the moment, when sales growth does eventually start to recede then companies will be hit by a double whammy. First of all, markets will become more competitive as sales growth falls (often reducing profit margins) and wage costs will continue to rise due to the delayed impact mentioned above. Share prices trading on high earnings multiples are the ones hit hardest.

Technology shares

Over the last few years we have seen many technology companies floated on the stock market with valuations which were obscene. Many of these companies may never make a profit and even the better ones could take years to create a significant return. As markets are flying high, investor appetite for risk follows suit and technology shares are very often in demand. One of the best ways to identify overvalued and undervalued markets is to monitor the price performance of small, medium and large technology companies. To a certain extent they will reflect underlying investor sentiment.

The herd mentality

As markets continue to rise many “investment sheep” will continue to follow investment trends and plough more and more money into markets. This is all good and well until the markets turn and we see a spate of profit-taking. A trickle of profit takers can very quickly turn into a stream which can then turn into a torrent of selling. Suddenly, valuations of yesterday were “out of kilter” with the economy, prompting more investors to sell up, sometimes at any price. As more negative reports and comments emerge, this can place more pressure on stock markets creating growing negativity amongst investors. A rush for the exit door!

Conclusion – Stock market corrections

Investors will push share prices to levels which are unsustainable because of greed and they will push markets down to levels obviously oversold because of fear. This is simple human emotion and as much as we’d like to take this out of investment equation, it is a very strong driver for investment markets. Stock market corrections are a fact of life – spotting them is not as easy as you might think!

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