With stocks having experienced their worst three-day decline in months last week, investors couldn’t be blamed for coming into this week thinking that the bad old days had returned. Instead of each session finishing at the high of the day and with a flurry of last-minute buying, traders have been treated to program-induced market volatility lately.
Given that it’s a new year and that stocks have been rallying uninterrupted now for more than ten months, it is natural to wonder when the much anticipated “correction” (generally defined as a drop of -10% or more) will begin. Corrections are commonly part of the game each year and are not to be feared from a big picture perspective. However, being nimble enough to step aside during a double-digit dip is likely a goal for most investors these days.
Over the course of the advance, we’ve looked back at history in an attempt to try and determine what we could or should expect next. On the topic of pullbacks in stock market indices, history has turned out to be a very good guide so far. For example, our research showed that during the periods immediately following the ends of bear markets and recessions, pullbacks tended to be both short in duration and shallow in depth.
By looking at the past, we also learned that after a surge in breadth, the market’s corrective phases tended to be even less severe than normal. Thus, our research made it relatively easy to stay with the bull camp during some sloppy periods over the last 4-6 months.
That Was Then, This Is Now
However, as the song goes, “the times they are a changing.” You see, a recent study done by Ned Davis Research suggests that the odds of a more severe correction have now increased dramatically. The key to this study is the fact that we are now six months past the likely end of the recession.
Most investors know that the stock market is a discounting mechanism. When its predictive powers are functioning properly, it is said that the stock market looks 6 to 9 months into the future. The idea is that the price action of the market will discount what is likely to occur in the future.
Thus, it makes sense that stocks tend to avoid any serious bouts of selling during the first six months after a recession has ended as during this time, traders are typically looking ahead to brighter days. This is also the phase when the economic and earnings data doesn’t really mean much to traders. Everybody knows that most economic data is backward looking. And as such, traders are able to brush the rearview mirror data aside and keep buying in the face of weak data in the hope that things will improve in the coming months. Sound familiar?
However, at some point the data does begin matter and must deliver on the “discounting” that traders did in anticipation of brighter days ahead. History suggests that this situation begins to present itself sometime after the recession has been over for at least six months. And since most economists agree that the recession ended in the June/July period, investors had best be on their toes.
What Does History Say Now?
Since 1933, there have been a 13 cases of recessions ending that we can review. In looking at the market action between six and eighteen months after a recession’s end, it is VERY clear that the odds of a substantial correction increase. Whereas the median maximum decline during the first six months following the end of recessions has averaged -5.4%, the declines in the six to eighteen months after recessions ended have averaged a more threatening -16.5%.
This is likely due to the idea that traders tend to overdo moves in both directions. So, as the mood begins to improve, buyers may wind up pushing prices past fair valuation points. And then when the data finally catches up, oftentimes a correction ensues.
Of the thirteen prior cases where recessions have ended since 1928, the maximum correction has been at least double digits ten times. Thus, we can say the odds that the biggest correction following the end of a recession will be at least 10% or more is 76.9%.
Of those corrections that were at least double-digits, the average decline was a fairly scary -19.42%. So, using history as our guide, if any of the pullbacks that occur in the next year makes it to double digits, it just might be a good idea to pull the plug
Already on the sidelines (lightly short) and getting ready to become very short. This market is going much lower. Look at the currency trade - the $ and the Yen are strengthening (these are safe haven currencies) while the Euro and commodity (risk currencies) are heading lower. This could turn around but until it does I am skewed to the short side of things. This is what the hedge funds trade to leverage up their positions - it is agood "tell".