After a blowout year in 2013, the pundits are saying the market is overvalued and that we’ve been due for the current fall in prices. The word “correction” is used frequently in regards to the recent pullback. The talking heads on Bloomberg and CNBC may be right, but I worry the word “correction” has implications which lull investors into a false sense of security.
According to Merriam-Webster, a correction is “a change that makes something right, true, accurate, etc.” Consider the implications of this definition. By extrapolating Webster definition, there must be an intrinsically true value for an asset that a correction more nearly approximates. Sadly, that simply isn’t true.
A correction has a specific meaning for the investment community, and we should consider their definition as well. Investopedia – an online dictionary that focuses on finance and investing – defines a correction as “a reverse movement, usually negative, of at least 10% in… an index to adjust for overvaluation.” The definition continues: “Corrections are generally temporary price declines interrupting an uptrend in the market… A correction has a shorter duration than a bear market or a recession, but it can be a precursor to either.”
The Investopedia definition is embarrassingly circular. It appears the only way to tell if a pullback in asset prices is a mere correction or a harbinger of a bear market is after the event has occurred.
Put another way, market prices are a consensual aggregated agreement on prices, but there often is no basis to their truth other than historical averages or an estimation based on some educated guess, like a net-present value calculations. Don’t misunderstand: these approximations have value for investors. We simply challenge the word “correction”. A “correction” implies a true, verifiable value to assets which, now that asset prices have fallen, we must have concluded. Furthermore, a “correction” implies the price drop is temporary, when the truth is nobody knows how long the decline in prices will last.