I'd Rather Be Right Than Consistent

During my latest appearance on Kudlow & Company last week, I briefly described how the market correction should produce a two-wave down cycle. Allow me to elaborate.

Throughout this bull market, there have been five advances of 10% or more. After each advance, a modest 5% or so market correction ensued. The common characteristic for each correction has been the number of down waves each took to complete the correction.

Of the five corrections thus far (not including the current one, which would be number six), four had two down waves of selling and one had three down waves (early 2004).

The amount of time for each correction ranged from as short as 4 weeks (last spring, if you don’t count a third wave, which came close but did not make a new low) and as long as 4 months (the three wave of 2004).

Presently, we are in the first wave, which should culminate with a rise in bearish sentiment and volatility. If I had to pick a price point, the 200-day moving average looks as good as any. That means for the S&P 500 the 1350 level. Time frame? I would suspect sooner rather than later, perhaps within a week or two. If the first wave plays out as outlined (from my lips to God’s ears), that should generate a sufficiently oversold market, which should then enable the market to stabilize and likely oscillate around that moving average or bounce off it (not unlike the first down wave last May).

Given the technical damage done, the highly volatile emerging markets, a Chinese government intent on cooling an overheated domestic stock market (and, thereby, decreasing the odds of a meltdown in next year’s all-important Olympics), the Bank of Japan’s deference to cool global liquidity (by taking the froth off the carry trade) over their domestic needs (a fragile Japanese recovery), and emerging concerns over 1Q07 earnings, stocks face many headwinds in the immediate days ahead.

The odds of a second wave to the correction look favorable. The negatives noted above will likely be joined by a new set of concerns centered on 1Q07 earnings and more bad news from the Middle East.

Next month earnings season kicks off and single digit gains are projected. A single digit earnings gain for 1Q07 will break the multi year string of consecutive double-digit earnings growth. Talk of a slowing economy should fill the media. Inflation, however, will likely not slow. And the two will likely produce some commentary regarding (are you ready) stagflation! Now add to this mix the anticipated spring offensive by the Taliban in Afghanistan and the likelihood for the second wave looks promising. I say promising because that should resolve the correction.

The issue of a price point for the second wave is much more difficult (not that picking any price point over the very near term is anything more than a fool’s errand). However, if the US equity markets are to incur its long anticipated 10% correction (thereby breaking that multi year string of no 10% corrections), then a price point would be in the low 1300’s for the S&P 500.

Investment Strategy Implications

History teaches us that the technical damage done last week takes time to repair. Given the dismissive comments of many commentators and strategists expressing their “it’s just a correction” point of view suggests, however, that it will take more than a garden variety 5% haircut to shake their confidence.

On Kudlow last week, Larry asked me what one single issue stands out re why I believe in my cautious view on stocks. My reply was complacency.

Complacency is a very broad area, one that I will elaborate on in future reports. However, being complacent sounds a lot like being consistent. And the alleged quote of Winston Churchill, “I’d rather be right than consistent”, expresses my sentiments.