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Finance Blog

Can you time the market? What's the right strategy for the average investor? 

Market Corrections, When to Panic

Anthony McCloskey

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A correction is a reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation. The latest stock market correction occurred on February 8, 2018 as the DJIA and the S&P 500 fell more than 10% from their recent highs hit in late January, 2018. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a bearmarket or a recession, but it can be a precursor to either. A correction is very different from a crash since it measures the the percentage decline from the most recent high. A crash is generally considered to be a 10% or more decline, irrespective of the most recent high.

One way analysts attempt to predict whether a market is headed for a correction is to compare one market index to a similar index. For example, if the U.K.'s FTSE 100 has recently underperformed, the Standard & Poor's (S&P) 500 in the United States might follow suit. When the market is showing a trend of closing lower, a correction may be at hand. However, a correction in the market or index as a whole does not necessarily tell how any one stock is performing. A stock within an index may remain strong despite a correction. A stock could also perform about the same as the overall market during a correction, or it could plummet even further than the overall market. A correction can be an opportunity for value investors to pick up good companies at bargain prices.

Market corrections in the stock market are fairly frequent events. On February 8, 2018, the DJIA and the S&P 500 both fell into a correction falling more than 10% from their highs on January 26, 2018.  Prior to this most recent correction, we have experienced 36 corrections in U.S. markets since 1980, and the S&P 500 fell by an average of 15.6% from peak to trough during those periods. One year after that, on average, the S&P 500 returned 16% from the low. Two years after that, on average, the S&P 500 returned 28% from the low, according to LPL Financial. Only 10 of the 15 corrections in the S&P 500 turned into Bear markets. Prior to the correction during the second half of 2015, the stock market had gone nearly three years without a correction. Corrections also tend to be relatively short-term phenomena. On average, a market correction lasts about three to four months. During the recent stock market dips in September 2015 and again in January 2016, in each case, the S&P 500 was able to retrace most of its gains within roughly two months of entering correction territory.

The stock market is fairly volatile on a short-term basis but has a strong track record of success over the long-term. Many view corrections as an opportunity for the stock market and traders to digest recent gains and avoid a sense of irrational exuberance in the short-term. For investors, corrections provide a chance to see how truly comfortable they are with market risk, and to make changes to their portfolio if warranted. They also provide investors with an opportunity to potentially add companies at discounted prices, or to dollar cost average down on existing positions.

From July 13 to July 26 — 10 trading days — the VIX, (+13.20%)  closed below 10. On five of those days, the S&P 500 Index SPX, (-1.33%)  closed at a new all-time high. And on seven days, the benchmark index traded at a new intraday record. So the market had been advancing slowly and methodically, but in doing so it has also created a severely overbought condition, especially in terms of volatility indices. 

As for upside resistance, there isn’t any in the classic sense, since the S&P 500 is still trading at new highs. The S&P 500 has only just recently traded above 2,800, but has yet to stay there.

Equity-only put-call ratios remain bullish. The standard ratio has developed a little “wiggle” over the past few days, but at this point, the computer analysis programs are still grading this chart as being on a buy signal. Meanwhile, the weighted ratio continues to make new relative lows daily and is thus solidly on its buy signal at this time.

Market breadth is only mildly bullish. The breadth oscillators have been on buy signals since July but were never able to register the kind of strong overbought reading that I like to see when the S&P 500 is breaking out to new highs. Now, with some recent slowing action in breadth, both of those oscillator buy signals are in jeopardy. Even a day of modestly negative breadth will roll them back over to sell signals. As we’ve noted many times since last November, breadth has just not been strong enough — in either direction (no “90% days,” either “up” or “down” since the election) — to keep these breadth oscillators from flip-flopping back and forth between what have become relatively meaningless buy and sell signals.

New highs vs. new lows is also a positive indicator, as new highs continue to dominate new lows. Since that upside breakout on July 12, new highs have averaged 177 per day, while new lows have averaged 16. That is dominance, and it means that this longer-term indicator is still positive.

So now we reach the subject of volatility. It had remained low that it had been analyzed, re-analyzed and cross-analyzed by every commentator and media “expert” on TV, radio and the internet. What can one say, besides the fact that when VIX is low, stock prices can continue to rise — and they certainly did. As noted earlier, VIX had closed below 10 for 10 consecutive days, not that long ago. That is a record, shattering the previous record of six days, when the “old” VIX, VXO, (+12.68%)  was extremely low leading up to, and including, the Christmas holiday in 1993.

Clearly, VIX was in an overbought state, but as we all know, overbought does not always mean “sell.” So where would I sell? I still, rather arbitrarily, use 13 as the demarcation line for VIX. If it trades above there, and especially if it closes above there, the wheels could begin to come off of the bullish stock market bandwagon, as we have seen most recently. Until then, the bulls had their way. Always remember Keynes’ admonition that “the market can stay irrational for longer than you can stay solvent.” After that long period of low VIX in 1993, there was something of a market correction a few months later, but VIX remained below 20 for the most part for another two years after that.

In summary, all indicators continue to trend bullish, although some are not far from rolling over to sell signals. Of this bullish lot, the most important is the chart of SPX, and as long as that is bullish, the intermediate-term outlook is positive. The overbought condition in volatility warned of a sharp, but likely short-lived correction, and that is probably close to completion. But that won’t change the intermediate-term picture  unlessthe major support levels of the S&P 500 are taken out.