What is a “correction,” exactly? Is one going on now?


A correction is the signature countertrend movement of a bull market.

It’s normally short–lasting two or three weeks.  It’s also shallow, although psychologically  it may not seem like it at the time.  Typically, the decline will be more than 3% but fall considerably short of 10%.

trigger vs. cause

I think it’s important to distinguish between the trigger for a correction and its cause.

The cause, which is always valuation, is usually easier to see.

Stock markets are ultimately driven by the economic performance of the companies whose stocks are publicly traded.  Bull markets occur during periods when corporate profits are not only expanding now but are also expected by investors to continue to do so for an extended period.  During times like this, investors can easily  become overenthusiastic and bid stock prices up to levels that are too high too soon, given consensus expectations for profit growth.  In fact, they tend to do so repeatedly.

Actual earnings expansion may eventually show–and it often does, in bull markets–that the consensus is too conservative.  But the market rarely stands still for an extended periods of time.  It either goes up, or it goes down (don’t ask me why, that’s just the way it is).  So if the justification for the price you’re paying in February for a stock will only come through an earnings report that will be made in October or in the following January, your stock probably isn’t going to sit there and wait.  If there’s no way it can go up for now, you can be very sure it’s going to start to go down.

Put a slightly different way, if the consensus thinks that S&P 500 earnings will be at best $100 for 2011 and that investors will be paying 14x for those profits, the consensus target for the S&P–until the market begins to factor in 2012 earnings–is 1400.  At 1350, this implies only about 3% upside for the market for, say, the next six months.  That isn’t enough financial incentive to choose stocks over some other, less risky investment, in my opinion.

It isn’t that the market thinks bad things will happen in the economy.  It’s a question of the odds of making a satisfactory return.  Sooner or later, this fact dawns on investors.  They slow down their buying to a trickle.

This is the position we were in a week ago.

What must–and always does–happen in this situation is that the market has to decline enough to restore favorable odds.   Last year the magic number for “favorable” seemed to me to be more than 10% but less than 15%.  My guess is that this year the number is lower,because investors are more confident, maybe 10% or so.

The trigger for a correction can be anything.  Many times it comes out of the blue. You should also note that the trigger doesn’t necessarily have to make any sense.   In 2010, for example, INTC reported the first of a series of stunningly good profit results early in the year.  The consensus concluded (incorrectly, as it turns out) that this was the high point for tech earnings in the current business cycle.  So the entire market, which had been a bit frothy, sold off.

This year the trigger is unrest in the Middle East.  My guess is that if equity markets had been 10% lower, stocks would have shrugged off events in Libya.

where are we now?

Proceeding in logical order, the first question to answer is whether we are still in a bull market or whether what we are seeing now is not a correction, but evidence of a reversal of the markets from bull to bear.

True, market tops are notoriously difficult to recognize–more so for always-bullish growth stock investors like me.  But we’ve just begun to see economic recovery take hold in developed markets.  Corporate profits seem to me to be very likely to continue to expand.  Valuations aren’t crazy high.  Interest rate hikes are a long way away.  Therefore, I interpret what we’re in now as a correction.  (Also, as it turns out, I’ve been writing that one is due for some time.)

Applying the rules of thumb I outlined above, stocks in the S&P 500 should be weak for another 5-10 trading days and bottom somewhere around 1250.

On the other hand,  there seems to have been a mini-panic in New York trading around midday last Thursday that may have taken a lot of the negative sentiment out of the market.  From intraday high the previous Friday to intraday low on Thursday, the S&P fell around 4%, which would just barely qualify for the depth of a decline.

I think trading in the next few days will be interesting to watch.  Last week’s decline really wasn’t deep enough or long enough to qualify as a correction, no matter what happened on Thursday.  So there should be more weakness to come, unless underlying sentiment is super-bullish.

what to do in a correction

As I’ve mentioned a number of times in other posts, stocks that have gone up a lot usually suffer the worst in a correction.  “Clunker” stocks (and everyone holds one or two), on the other hand, don’t decline much because they’ve never gone up.  The most useful thing to do when the market is declining is not to hide under the bed, but to upgrade your holdings.  Sell the clunkers at relatively attractive prices and buy healthier stocks at a discount.  You should make gains from doing this.  At the very least, you’ll have gotten rid of securities that would have continued to subtract from performance.

I found myself doing this on Thursday.  That’s pretty early in a correction to be acting.  I’ll be interested to see how this works out.

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