Sell-off was much-needed ‘castor oil’

NEW YORK – As difficult as it might be to explain to investors who lost a total of $632 billion in Tuesday’s market carnage, a correction isn’t necessarily a bad thing. It may have reacquainted investors with the concept of risk.

“Corrections like this are the financial equivalent of castor oil,” said Hans Olsen, chief investment officer at Bingham Legg Advisers in Boston. “It’s good for you, you don’t like it, but you have to take it.”

Stock market rallies are psychological in nature, and the exuberance of investors to get in on a good thing feeds more buying. Soon, exuberance overcomes rational measures of the market’s health, such as earnings growth. Share prices no longer reflect the risk of a slowing economy or weaker profit growth.

When that risk is finally understood, stock prices readjust.

Over the past six months – until Tuesday, that is – the Dow Jones industrial average surged 17.6 percent without any kind of meaningful pause. That’s a long time for the stock market to go without a reality check.

“The sell-off reintroduced the concept of risk to the market that had been absent for quite some time,” said Russ Koesterich, senior portfolio manager at Barclays Global Investments in San Francisco. “Investors very quickly and violently reappraised their appetite for risk.”

In this market, they also recover from the blow quickly. The Dow gained about 90 points in afternoon trading Wednesday after the sell-off. And it’s reasonable to expect a quick recovery.

According to Citigroup, when stocks have fallen 3 percent in one day, they’ve recovered handsomely within three months 80 percent of the time.

With investors now taking risk into account, the question now becomes whether the long-term market rally can continue – or whether it’s heading for a full-fledged bull market correction. In bull markets, a correction represents a 10 percent drop in stock prices. The current bull market dates from Oct. 9, 2002, and has yet to experience a correction. Indeed, the Dow had gone a record 949 straight sessions – nearly four years – without a one-day drop of 2 percent.

Bull market corrections are fueled by persistent concerns about fundamentals such as the economy or earnings growth. At the moment, both are troublesome.

The housing market remains very weak: new-home sales plunged in January by the largest amount in 13 years. Growth in gross domestic product has slowed to 2.2 percent annually in the fourth quarter of 2006 from 5.6 percent in the first quarter last year. And former Federal Reserve Chairman Alan Greenspan said Monday that the economy runs the risk of slipping into recession by year’s end.

Corporate profit growth, the primary driver for stock prices, is likewise expected to slip. For every one company that issued a positive forecast for first-quarter earnings this year, three other companies issued negative forecasts, according to Thomson Financial – the worst showing in six years.