This week the S&P 500 Index touched 1,800 before pulling back a bit. Hitting round numbers in the averages usually creates some profit taking among investors. A number of indicators are also hinting that a minor correction could happen at any time.
A stock market decline in the magnitude of 5-6% is overdue. I’m not sure if it will happen this week or next, but I am pretty sure it is just around the corner. I could be wrong on my timing although the evidence is building. Some of the variables I watch are flashing red lights, others are simply amber and a few remain green.
One indicator I watch is small cap speculation. Frothy markets are wonderful for penny stocks. Speculators day trade these puppies and can make as much as 8-10% in a short time period if they bet on the right horse. In the last few days those stocks are not working as well as they have over the past month. They are usually a leading indicator for market turns.
Then there are the momentum stocks. In bull markets there are always stocks that seem to go up and up almost every day until they don’t. Take the current mania for solar stocks and companies that produce 3 D printers. In the last few weeks some 3 D stocks have actually doubled. But this week, these same stocks have been down as much as 20-30%. When momentum stalls, the overall market is usually not far behind.
As a contrarian, I also pay attention to investor sentiment. The more bullish investors become, the more worried I get. Proprietary crowd sentiment numbers indicate we are at a level where the market has pulled back several times since 2011.
Readers may ask how this cautionary column squares with my belief that we have entered a secular bull market that could last for years. A secular bull market does not mean that the markets go up and up without experiencing declines. They do, and some of them can be severe. It is what keeps the bull going. Periodic sell offs that allow the markets to consolidate its gains and give new buyers a chance to get in is the historical formula for a long-lasting uptrend.
What I am hoping to see is a short-term decline in which the S&P 500 Index falls to its 100 day moving average. That is around one hundred points lower from here. In the grand scheme of things, it’s no big deal. It would allow the markets to then stage a traditional Christmas rally sometime in late December continuing through the New Year.
I’m sure you are asking what this means for your portfolio. The short answer is a paper loss in your portfolio. Some investors may be tempted to sell now and jump back in after the correction. Good luck to you if that’s your plan. There is no guarantee that the markets will cooperate. What if the decline is only 2%? What if I’m wrong and the markets continue to grind higher without a pullback? Are you willing to be glued to the computer screen eight hours a day watching the markets for a turn that may not come?
If you can’t take a short-term loss 5-6% paper loss in your portfolio, you are invested far too aggressively. These kinds of minor declines are the cost of doing business in the equity markets. They happen all too frequently. Get used to it, or reduce the risk in your portfolio permanently.