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Booms and busts have now become a normal part of the business cycles. Due to monetary inflation, the value of assets is expected to rise every year. However, a lot of time this rise does not happen. Sometimes, this rise is replaced by a fall. This fall is called a market correction or a crash depending on the magnitude of the fall.
On the other hand, sometimes markets simply remain stagnant for a long period of time. This wasn’t considered to be a correction in classical theories pertaining to stock markets. However, economists have now come up with a view that stagnation is actually a hidden correction. They have given this phenomenon a name and it is called “time correction”
In this article, we will have a closer look at the concept of time correction and how it affects the marketplace.
A market correction has traditionally been defined as a fall in the value of an asset that is greater than 10% but less than 20%. If the fall in value is greater than 20%, it is called a market crash. If the fall is less than 10%, well it is simply the daily functioning of the markets and some fluctuation is part of the process.
Corrections are a relatively amicable way to solve the problem of an overheated market. Crashes cause unparalleled investor agony. Corrections are also painful but most investors survive them.
Notice, carefully that the above definition of correction is in terms of percentage points. Therefore there has to be a dip in the price of a security for correction to take place. Modern economists do not agree with this. They believe that the definition of market corrections should be wider and should accommodate stagflation related scenarios. They believe that the fall in price is just one of the possible scenarios and hence have called it “price correction”
Time correction, on the other hand, is when the price of securities stay stagnant for an extended period of time, let’s say, three years! In this scenario there has not been any explicit fall in the value of the asset. The value remains unchanged. However, implicitly investors have lost time value of money.
If the money invested in the asset was simply parked in a bank, it would be earning interest and therefore growing at a rate of return higher than zero. Implicitly the investors have lost money and there has been a correction in the value of the asset. Since the correction was caused by the passage of time, it is called a “time correction”
An investor’s wealth can be seriously eroded if they face a time correction while being leveraged. Consider the case of housing markets for instance. Leverage is extremely common in these markets and investors typically borrow close to 80% of the money at interest.
Now consider the case of a person who has borrowed $100 at 10% interest to borrow a house. In the first few years the interest will be close to $10 per year since almost all the principal is due. Hence, such a person is paying almost $10 to hold on to this bet.
Hence, if the price of houses does not rise more than 10% in the given period, they end up making a loss. If housing prices stay stagnant for 3 years, the investor stands to lose $30 in the way of interest paid or interest foregone. This is a fall in the value of an asset.
Leverage amplifies the rate at which investors lose money in the case of a time correction. In the absence of leverage, $30 would be a notional loss. In the presence of leverage $30 is an actual out of pocket cash flow loss! Also, if a large number of investors do not have the cash flow required to sustain this time correction, it could lead to foreclosures and even cause a price correction or even a crash in the marketplace.
It is therefore true that prices do not have to fall for investors to lose money. Even if they simply stay stagnant, investor wealth can be seriously eroded.
A small rise in price quickly puts the bears in action whereas a small fall in price quickly puts the bulls into action. Since neither is willing to relent, a stalemate seems like a natural solution.
The understanding of time correction is extremely important to investors, especially the ones who make leveraged bets since it has a very real impact on the cash flows and could potentially bankrupt them.
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