How a Market ‘Correction’ Should Affect Your Strategy

For the second straight October, individual investors find themselves in what’s known as a stock market “correction,” defined as a slide of 10% or more in leading indexes.

From its July 16 peak, the benchmark Standard & Poor’s 500 index of blue-chip stocks has fallen 12.1%. Meanwhile, the Russell 2,000 index of small stocks is down 11% since peaking July 15.

Perhaps the biggest question on investors’ minds is, “How is this market correction affecting my portfolio?” Just as important, though, is how should it affect your investment strategy--if at all?

Below are answers to some basic questions that may be on your mind.

Question: How bad is it, really?

Answer: It depends on your perspective. If you invested all of your money into stocks this summer--just as the markets peaked--then you would have lost slightly more than 10 cents on the dollar, on average. That’s not devastating news, but it’s no picnic compared with the bull market gains we’ve grown accustomed to.

The truth is, however, few investors put all of their money into the market at the very top. Millions of Americans invest small amounts of money in stocks each month through their company-sponsored 401(k) retirement accounts. By putting small amounts in each month, a strategy known as “dollar-cost averaging,” you would have avoided putting all of your money in at the very top.

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Q: So, should I view this as a buying opportunity?

A: Throughout the ‘90s bull market, investors have been told to “buy on market dips”--and the advice has paid off. It certainly was the right thing to do last year, when the markets came roaring back from a late-summer slide. From Oct. 8, 1998, the S&P; 500 wound up surging nearly 29% in the next three months.

Bear in mind, though, that the environment for investors is different now than it was a year ago. Last year, the Federal Reserve was cutting short-term rates to jump-start a struggling global economy. Because higher rates make bonds an attractive alternative to stocks, by cutting rates, the Fed in effect made stocks more attractive to investors.

This year, the Fed isn’t cutting rates--it’s been raising them.

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Q: What if I invest primarily through my 401(k)?

A: First off, for most investors, 401(k) money is long-term money. And as long as you have, say, 10 years or more to invest, short-term market volatility shouldn’t make you change your long-term strategies, financial planners say.

Also, remember that by investing small amounts of money each month through your 401(k), you are dollar-cost averaging. And “for dollar-cost averaging to be effective, the market has to go down sometimes,” said Gerald Perritt, editor of the Mutual Fund Letter.

Think of it this way: If you invest small amounts each month, and the stock market continuously rises each month, you are consistently buying stocks at ever higher prices. Momentary downturns allow you to buy low so that eventually--at retirement--you’ll be able to sell high.

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Q: If this is just a dip, and not something bigger, where do potential opportunities lie?

A: It depends on whom you ask--and their outlook on the economy.

Perritt, for instance, thinks you have to look at those sectors that have good long-term prospects but which have already been hit hard.

One good place to start, he said, is health-care mutual funds, which have already fallen 3% on average this year, while technology funds have soared.

Eric Kobren, editor of the Fidelity Insight newsletter, agrees. He recommends Janus Global Life Sciences fund, and Fidelity Select Health Care and Fidelity Select Biotechnology as solid choices in this sector.

Rich Moroney, editor of the Dow Theory Forecasts newsletter, favors growth companies with strong sales growth but “reasonable” price-to-earnings ratios. He thinks they can be found in small-company growth stock funds and mid-cap growth funds.

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Q: If this isn’t just a correction, can I still put money to work in stocks?

A: Even though she views this correction as more than a short-term dip, Geraldine Weiss, publisher of the Investment Quality Trends newsletter in La Jolla, said you should never be entirely out of stocks.

That’s as long as you own high-quality, dividend-paying blue-chip stocks.

For bearish investors looking for buying opportunities, she recommends “letting good values come to you.” For instance, she notes that shares of Raytheon, the defense and electronics company, have already been cut in half this week. Yet the stock’s dividend yield is more than 3%.

Weiss also thinks safety-minded investors may find opportunities in the utilities sector.

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Q: If I’m thinking of buying, how should I buy?

A: If you’re thinking of investing through stock mutual funds, remember that the end of the year is when they tend to make their taxable capital gains distributions. In other words, your so-called buying opportunity might slap you with an immediate tax bill.

Analysts note that many emerging markets funds, and some foreign and natural resources funds, don’t expect to pay out capital gains this year.

What if you want to invest in a diversified domestic equity fund?

Some funds have already made their year-end distribution. But if the fund you’re considering hasn’t, think about buying on this dip through a tax-deferred retirement account, such as an individual retirement account, analysts say.

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Q: What about bonds?

A: If you’re thinking of adding stability to your portfolio through bond mutual funds, this isn’t the best time to do so, analysts say.

That’s because bond prices move in the opposite direction of market interest rates. As interest rates are rising, the prices of older bonds with lower yields are falling in value--thereby reducing the value of bonds held in bond funds.

On the other hand, if you’re thinking of buying individual bonds and plan to hold them to maturity, Sheldon Jacobs, editor of the No-Load Investor newsletter, said “now’s the time to be considering short- or intermediate-term bonds”--especially Treasuries.

Five-year Treasuries are yielding nearly 6% today, versus 5.65% on June 30 and 4.54% at the start of the year.

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Surveying the Damage

Sources: Bloomberg News, Bridge Information Systems