The Complacent Correction

Perhaps my May 24th forecast of a market correction (see blog posting, “4 Reasons Why a Market Correction is Imminent”) is now underway. If so, the issue then becomes just what type of a correction will this be?

I submit to you the following three versions of a market correction that US stocks are likely to experience:

1 – The Alfred E. Newman Correction

This version is more anecdotal than quantitative and easily fits in magnitude with version #2 below although less violent, a relatively tranquil-like downward float. The strategist and pundit talk should center on the “healthiness” of a correction - which is a true statement but of concern when accompanied by a sanguine tone. The quantitative manifestation of this version follows.

2 – Painfully Short and Sweet (scare the bejesus out of ‘em) Correction

In 2005, 2006, and early 2007, this version (<10%) has been the correction du jour. Sharp down, seemingly out of the blue, yet, when completed, not all that bad. Kind of like some nasty tasting medicine – bitter but brief. Final damage is in the 5 to 8% range.

3 – The Real Deal

The US equity markets have not experienced this version at any point during this entire multi-year bull market. I am speaking of the >10% variety. A steady corrosive decline down (versus the sharp, sweet #2 version) that, after a while, shifts sentiment from complacency to concern to capitulation.

Investment Strategy Implications

Regardless of which version you think will occur (I suspect most will opt for versions 1 or 2, which means the contrarian in me says to lean toward version #3), the issue of what to do comes to the fore. If you believe in version 1 or 2, then you’re a buy-the-dip investor. After all, that’s what has paid off recently*. If you’re a version 3 person, however, then the issue of correlations becomes a consideration.

Given the high degree of correlations among and within markets, the ability to “bury the money in defensive issues” is taken somewhat off the table. Granted, there is some comfort in the lower beta aspects of certain sectors and styles, but in fully synchronized, highly correlated markets, across the board losses tend to be more certain. Accordingly, non-correlated assets are nearly impossible to find, which leaves only the asset allocation decision as a tactical course of action for most investors. And that may a problem for some, as it is a market timing approach that many investors (as opposed to speculators) are not completely comfortable with.

Note: Going into this week, the Model Growth Portfolio (MGP) is currently 86% in equities with several hedged positions, including a short in long term US Treasuries (TLT) and a long position in the Ultra Short QQQQ (QID). To learn more about the strategies employed and MGP, click on the Blue Marble Research services link to your left. A modest subscription is required.

*see May 29 blog posting "Just How Smart is the Smart Money" re the behavioral finance tendency of recentness.