Thursday, January 15, 2015

Corrections happen

Any short-term drop of 5% to 19% within a long-term rally is what I refer to as a "correction".  My medium-term stock market timing method usually does not predict corrections, and that's by design.  If I were to find a method that sold stocks before every correction, I might end up buying and selling ETFs a dozen times or more per year, and that's far too complicated and full of trading fees for my taste.

The reason I stop calling it a "correction" at 20% and start saying "bear market" or "crash" isn't just because smaller drops are more common.  Historically, drops of more than 20% rarely bottom out in the 20% to 25% range - rather, 20% drops usually continue down much further before turning around, and that makes them worthy of the name "crash" (when it's quick) or "bear market" (when it takes a year or more), and it also makes it worth my while to predict when a drop of 20% or more is imminent, while not worrying about drops of 19% or less.

I'm raising this topic now because the small dip that the stock market is currently in is the kind of dip that sometimes grows into a larger correction - but NOT a crash.  The S&P 500 index closed at 1992 today, which is only 4.6% below the all-time high of 2090 that occurred last month.  It's not even a correction yet by my definition, but don't be surprised if the market falls further from here.  A secret experimental method of mine (one which I don't even use in the market bots!) says that there's a chance the S&P may fall as low as 1750 before turning around, and that would make it an almost-headline-worthy 16% correction.

My long-term indicators are still bullish, and even contrarian short-term sentiment is relatively pessimistic/ bullish, so my bullish outlook hasn't changed.  Indeed, today may end up being the bottom of the current dip.

To those investors who are uneasy about riding out a possible hefty correction to come, I ask which worst-case scenario you would rather deal with: (1) stay in stocks, ride out a correction and then benefit from the next leg of the rally, or (2) cash out now and miss part of the rally when it resumes tomorrow?  The market bots are designed to choose the former, because on short time scales the market has a tendency of doing the opposite of what we expect, and most people end up regretting trades based on short-term bets.