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Crash or correction: how to spot an opportunity

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The COVID-19 outbreak and the consequent global share market sell down initially caused pain to portfolios. However, many investors are alive to the idea that a market event like this could offer a once in a decade buying opportunity. The challenge is in finding the better way to take advantage of the disruption in the stock market.

Among professional traders there is a saying: "We are all geniuses with hindsight."

This refers to the fact that once an event is in the past it is a simple matter to identify the correct course of action. Newer traders sometimes develop the habit of telling their colleagues what they "would've done", after the fact. This is as annoying as it is useless. The goal for both traders and investors is to identify market opportunities in real-time.

The "right" decision for any investor depends on individual circumstances. Investors may have different goals, amounts of capital, time-frames, risk appetites and experience. All of these factors should contribute to an investment decision. Further, investors' views of what is happening right now, and what may happen in the future, are important.

For some investors the question of when the share market hits bottom and turns higher is immaterial. Those with longer timeframes could be in this category. A person in their 20s, with 40 years of saving ahead of them, may see certain shares as bargains at current prices. Their far away investment horizon means that they are prepared to weather any further short term drops to lock in what they see as value in shares right now.

Those buying at current prices may turn out the big winners if the market continues to rally, or they may suffer losses. No-one knows the future with certainty. Investors practising dollar-cost averaging are acknowledging this uncertainty. By putting the same dollar amount to work in the share market, on a regular basis, they even out the swings in share prices over time.

Either of these approaches may suit an individual's circumstances.

For other investors there is a stronger desire to time the market, and ideally buys stocks at close to their lowest levels. The first question for these investors is whether the current situation is a correction or a crash.

Corrections can be short-lived. "V" shaped recoveries were a feature of the US bull market over the previous decade. The S&P 500 index made regular pullbacks of around 10%, only to recover sharply to make new highs, just weeks or sometimes days after the sell down. Those who believe the global pullback is a correction may have already jumped back into stocks.

The size of the pullback runs against the correction theory. From the late February peak to the March low, the Australia 200 index dropped 39%. The size and sheer speed of the fall suggests a crash is unfolding, rather than a correction. Past performance is not necessarily a guide to the future, but historically crashes play out over months and years, not days and weeks.

From mid-March 2008, in the midst of the GFC, the Australia 200 index rallied more than 18% over two months. This is not predictive, but shows that extended rallies have occurred before, in a crashing market that went on to halve from its rally point.

Investors who see a crash unfolding are possibly waiting for signs of a market bottom. As share markets price the future, rather than the present, measures such as virus infection rates may not signal the turning point. Instead, investors may look for a sentiment measure as a sign of the low point for stocks.

Bull markets are born in despair. While friends and colleagues are asking "what should I buy?" the bull is still pulling the strings. It's only when most investors have given up on shares, and walked away, that a crash finds its bottom.

We're cutting through the confusion to help you manage your money during the coronavirus outbreak. Click here for more on how COVID-19 could affect your job, budget, super and investments.

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With more than 30 years' experience in the financial markets, Michael McCarthy is the chief market strategist for CMC Markets for Asia-Pacific. He provides local and global market analysis for the Asia-Pacific region, formulates trading strategies and plays a key role in educating clients. Michael has a Masters of Applied Finance from Macquarie University and specialises in derivative trading.
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