When Will the Market Correction Begin?

Even with Friday afternoon’s nosedive, the major indexes ended last week less than 2.5% below where they started it. The Dow and S&P 500 ended the week only about 2% off their recent highs, and the Nasdaq fell even less. Overall, the major indexes ended the month of May—supposedly the beginning of the market’s “unfavorable” season—with gains between 2% and 4.5%.

In short, many investors and advisors are still waiting for a real correction—usually defined as a drop of at least 5%.

If you’re one of them, you might want to familiarize yourself with the results of a study recently conducted by Stock Trader’s Almanac Editor Jeffrey Hirsch. He looked at 5% corrections in previous bull markets, and specifically at the time between them. Here are some of his conclusions:

“Those still expecting a pullback now have weakening economic data on their sides and a market valuation that no longer looks cheap with the S&P 500 currently trading with a 15 to 16 price-to-earnings multiple. The last argument frequently cited as a reason for a correction is the time the market has gone without one.

“This last argument is probably the weakest one of all and reminds me of the gambler’s fallacy. Although this fallacy does not correlate well to the market, it does explain how the human mind can reach an erroneous conclusion after observing a seemingly low probability scenario unfold. In the case of the market, the fallacy seems to be that after six-plus months without a correction of 5% or more, the market must be more susceptible now than it was in the second month of this rally.

“Admittedly, proving that six months without a 5% or more correction makes a correction more or less likely or has no impact at all on whether or not a correction is coming is not as easy as illustrating the gambler’s fallacy with a simple fair coin toss and some math. For one, the market has a bias and that direction is up. Up, because of monetary and fiscal policy that attempts to foster and support economic growth and corporate earnings. But, we can examine the S&P 500’s history and draw some conclusions. Because 5% is a commonly and widely accepted threshold for a pullback to be considered a correction, this is the value used. Obviously, many corrections ultimately exceeded 5% before the market recovered to its pre-correction level, but for this study every 5% decline was considered.

“Looking back at the last 64 years of S&P 500 trading seems to confirm that just because there has not been a correction for six months, does not mean it is more or less likely to begin now. For starters, since 1950, there were five full calendar years in which there were no 5% corrections; 1954, 1958, 1964, 1993 and 1995. The longest streak was 594 calendar days from December 1957 to August 1959. This streak nearly covered an entire bull market; it came up just two months short.

“All told, there have been a total of 299 5% corrections for S&P 500 since 1950. Of this number, 106 occurred in the 20 bull markets of the period. When all data is considered, a 5% correction occurred every 2.5 months on average. In bull markets, a 5% correction occurred every 5.2 months on average. From these statistics alone, one could argue that a 5% correction is overdue, however, when 5% corrections are grouped and ranked by the bull market that they occurred in, it becomes apparent that a long streak without a correction does not mean that a correction is imminent. Long streaks have occurred repeatedly in the past. To view the S&P 500 5% corrections chart, click here. 

“There have been two S&P 500 bull markets where there never was a 5% correction until the bull market ended. This occurred in the bull markets of October 1960 to December 1961 and most recently in the mini bull from September 2001 to January 2002. When looking at the current bull market (either from the March 2009 bottom or the October 2011 low) there have been twenty-one 5% corrections. If anything, this bull market was/is due a lengthy streak without a 5% correction. When the streak will end cannot be answered precisely, but it will end sometime—just as every other streak since 1950 did.”

What Hirsch’s analysis shows is that the last six months have a) not been that unusual, and b) don’t make a correction any more likely today than it was one, two or three months ago.

With that knowledge in hand, you should be less inclined to try and anticipate a correction, and happier to “make hay while the sun shines.” In fact, that’s what most of our Dick Davis Digest contributors are advising right now. Richard Schmidt, Editor of Stellar Stock Alert, recently wrote: “The stock market is sitting at all-time highs. It’s catching the attention of just about every investor. And the feeling is that the market is going much, much higher. As a contrarian, you know what that does to me. It sets off our warning lights. [But,] the trend is still clearly up. We don’t bet against the trend. But we do recognize when a rally within the trend may be growing weary. The current record-breaking rally is facing some difficult obstacles it will have to overcome in the next few months. We’re looking to see if those obstacles push the market down—or give it strength to grow further. As a result, we’re not making any changes in our allocations. We’re maintaining an 80% invested goal and a 20% cash goal.”

Also making hay is Michael Cintolo, Editor of Cabot Top Ten Trader, who wrote Friday morning: “It’s been a topsy-turvy week, which is what we thought was likely after last week’s sudden bout of distribution. And thus, our thinking hasn’t changed much—after an outstanding six-month advance, it’s only natural to see some digestion in the market to allow stocks to catch their breath and, just as important, to swing the sentiment pendulum back toward the fear side (or at least discomfort). …

“Overall, though, we’re not advising much change in your stance. Sure, if the market shows some persistent distribution (including some real breakdowns in leading stocks), we’ll change our tune—some intense selling would raise the odds of a ‘real’ correction or pullback. But at this time we’re keeping our Market Monitor in bullish territory, with the caveat that the near-term will likely include further ups and downs depending on the news of the day.”

So that’s today’s bottom line: don’t anticipate, just enjoy the trend while it lasts.

Wishing you success in your investing and beyond,

Chloe Lutts Jensen

Editor of Investment of the Week

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