Research & Advice

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Sharp, But Ordinary, Correction

January 17, 2011

 

  • The string of positive weekly stock market returns rivals that prior to the large correction that started in April 2010. A number of current technical metrics are also reminiscent of those in April. The similarity between the two rallies raises the question of whether the market is headed for a similar 16% correction.

  • At this point the worst-case scenario decline looks to be more consistent with an ordinary and regular and (ultimately) uneventful 7% drop in the stock market. There is no need for an actionable response to get very conservative.

  • Any correction (anticipated or undergoing) would be a good opportunity 1) to cull weakness from portfolios with the anticipation of reinvesting the proceeds into stronger positions, and 2) for growth-oriented investors, to shift investments from safe high-yielding investments toward those with a greater potential of capital appreciation.

  • In 2010 Berkshire Money Management took the easy road to equity-like returns without having to take equity-like risk (i.e. very, very little risk, based on our probability assessment of success). 2011 will be a different story; for those seeking equity-like return in 2011, equity-like risk will have to be taken.

 

Since the end of the November 2010 correction, the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ have advanced for seven consecutive weeks. Over that time, the DJIA and S&P have been lower for no more than three consecutive days and the NASDAQ for no more than two consecutive days. This virtually uninterrupted rally stirs memories of the rally prior to the April 2010 top, when the market indexes strung together an uninterrupted rally of eight consecutive weeks. The similarity between the two rallies raises the question of whether the market is headed for a similar 16% correction.

Regarding the April 2010 top, a year ago, in our Outlook for 2010, we wrote that:

“Consistent with our expectation of for a strong start to 2010, a correction, on average, could be expected to begin on April 6, 2010 (fairly close to the Sell-in-May-and-Go-Away seasonal pattern). … A probable worst-case scenario would be a 1977-like decline of about 21% after “only” reaching 1,200 points on the S&P 500 (which would rival the 1975 advance) in April of 2010…”

Thankfully, we fell short of the worst case scenario by about five percentage points. But the precision of the timing was uncanny, as was the consistent declaration on our part that the correction, as big as we expected it to be, would simply be an interruption of the primary trend, and not the resumption of a new bear market.

A few weeks ago, in our Outlook for 2011, we wrote that:

In regard to magnitude of an anticipated correction, “we have what is an uncomfortably aggressive Risk Level of 1,215-points on the S&P 500” and that in regard to the timing of such a correction it “is not at all unlikely to see it start in the days or weeks (as opposed to months) ahead.”

Instead of a worst-case scenario of a 21% drop in the stock market for 2010, at this point the worst-case decline looks to be more consistent with an ordinary and regular and (ultimately) uneventful 7% drop in the stock market. The lower threshold of the expected correction would be about 3% which, admittedly, is hardly worth mentioning.

We continued in the Outlook for 2011 by saying:

“We do not view the risk of the coming stock market correction as large enough to cause an actionable response in portfolio management (i.e. raising cash, or selling equities and buying bonds). But the recent rally coupled with a likely pullback may present a better opportunity for culling under-performing investments from portfolios, with the expectation of reinvesting the proceeds into other investments that we have on our radar screen. This would make sense as our 2011 Outlook remains positive and any near term pullback should be limited.”

There is no need for an actionable response to get very conservative (like we temporarily did in 2010 as we took the easy road to equity-like returns without having to take equity-like risk). 2011 will be a different story; for those seeking equity-like return in 2011, equity-like risk will have to be taken. Because the correction will likely be no more than a fairly shallow seven percent (a more modest three percent drop is the lower threshold of that same anticipated drop), we are not overly concerned with the timing of making growth-oriented portfolios more aggressive. That is to say, it doesn’t matter too much if the change happens at the top or the bottom of the market’s short-term cycle. Since the tools to time shallow moves are extremely blunt, Berkshire Money Management will be happy to observe over the next few weeks to see if we have a small opportunity to begin shifting growth-oriented portfolios to a more aggressive posture – but we just aren’t overly concerned about seeing the market hit the bottom of a correction before we begin to make that move.

Revisiting the similarities between the current market conditions and those of April 2010, there is more good news than bad news. Just as in April 2010, there are, at present, no indications of a major market top (Berkshire Money Management prides itself on being well experienced in calling major tops and bottoms, the stuff that keeps you from suffering through years like 2002 or 2008; in between those tops and bottoms is maintenance). The same condition exists today as it did then in regard to the relationship between Demand (i.e. Buying) and Supply (i.e. Selling). For the intermediate term, stock prices are in the midst of a healthy primary uptrend, as they were in April when the Advance-Decline Lines were at new rally highs.

It’s really only the short-term where there is evidence of deteriorating strength. For example, in both April as well as now, optimism readings have gotten too high and the market had become “over-bought”. Also, both rallies are guilty of signs of selective buying, as measured by the percent of stocks trading above their 10- and 30-day moving averages. In other words, the major market indices are advancing on the backs of fewer and fewer rising stock prices – a good opportunity to cull weakness from portfolios with the anticipation of reinvesting the proceeds in the near term.

So if short-term conditions today are so similar to those in April, shouldn’t we expect a similar correction, something in the range of 16-21%? We think not. The April top was preceded by a greater increase in selling. Corrections that are created by an increase of selling (i.e. Supply) are typically more damaging than those caused by an absence of buyers (i.e. Demand). The trigger for this correction will likely be an absence of buyers in the short-term as excess optimism has drawn in much of the available investable cash.

Bottom Line: We expect a stock market correction in the range of 3-7% to begin shortly. Stock market moves of this type are ordinary, regular, and (ultimately) uneventful. But given the expectation of Berkshire Money Management to add more equity to growth-oriented portfolios, the timing of the correction is worthy of discussion. Ironically, perhaps the most interesting part of that discussion is that the timing of a shift toward more aggressive investments is not worthy of much discussion.

Berkshire Money Management has shown great proficiency in the timing of major market tops and bottoms – many clients choose to use us just as a level of insurance in having their portfolios be moved to a more conservative posture at major market tops. We embrace our role as Risk Managers, so we do not wish to sound cavalier regarding an anticipated stock market correction, but the tools to time such small and commonplace corrections are far too blunt to be precise.

We are willing to wait a little longer (a few weeks?) to see if a 90% Down Day develops (90% of the total volume is Down; and 90% of the total price movement is Down) and thus signals a move closer to 7% than 3%, but the primary trend is healthy enough that we need not wait to recognize the very bottom of any correction. If the market drops a few percent over the coming weeks, we will want to take advantage of that.

But an over-bought market that continues to get bought-up can be bullish. As discussed in the body of this report, signs of selectivity and the fewer number of stocks pushing up the major stock market indices suggests, in part, that a correction is coming. If the stock market can avoid a correction and reassert itself with greater breadth (i.e. more stocks going up, as opposed to fewer) then that would be a positive sign suggesting that any correction would likely be at the lower end of the range, thus encouraging us to shift assets more aggressively.

Currently, in the short-term, it’s not so much the direction of the market that encourages a shift in investment allocation as it is the potential health of the market.