How to Prepare for the Inevitable Correction

Now that the S&P 500 has hit my full year target of 1050 (made last December 30 as published in the Wall Street Journal’s “MarketBeat” blog) - with 3 months still left to go, I might note, cyclical bulls (like me) who have turned increasingly more cautious over the past two months (as stocks moved well past their fair value targets) continue to sell into the rally. The portfolio consequences of this sell-into-strength decision are two-fold – reduced profits and reduced exposure to a pullback.

As stocks moved higher into overvalued territory, the first course of action was to maintain a portfolio’s equity exposure (assuming it was less than 100%) to the total assets managed, which for accounts managed by my company was in the low 90% range. When stocks continued to march ahead these past few weeks, the course of action shifted to reducing the equity exposure, which now stands in the mid to upper 80% range.

This modified market timing (a/k/a sector and style tilting) works best in portfolios geared for the long term and subscribe to the diversification with a tilt approach to managing money*. Eventually, stocks that have taken a shine to the stratosphere will feel the gravitational pull of profit taking, common sense, and a cooling down of the animal spirits momentum “investing”. A correction then ensues.

On the assumption that a correction will eventually occur (and it will), the timing of the correction may be domain of the foolish and the insightful but the process is not. From experience investors should assume that one of the following will likely occur:

Air pocket – investors rise one morning to find stocks gap open to the downside in a big way. Volatility rises as price action becomes more erratic with many whipsaw movements. Bye bye steady up, hello wild and wooly.

Sudden but moderate – a decline starts and continues as market pundits proclaim the healthy qualities such a Goldilocks version of corrections exhibits.

Erosion – the decline sneaks up on you. Slow, steady, and highly corrosive. The flip side of the past several months.

Of the three possibilities listed above, I would opt for #1, the air pocket. However, whatever correction does emerge, investors are best served by being clear about their portfolio strategy action steps before, during, and into a correction. I have articulated the general outlines of my approach. What’s yours?

Investment Strategy Implications

Eventually, stocks will experience a pullback. The gravitational forces of profit taking, common sense, and a cooling down of the animal spirits momentum “investing” will help markets absorb and reflect on where the fair value for an asset class belongs. At 1050, expectations now put stocks at 1170 (10% discount factor) 12 months hence, which means that operating earnings need to reach $78 by 3Q10 – a number that only the most optimistic of forecasters has recorded. Alternatively, there are those who argue that a higher than normal times P/E (15 times) is appropriate (e.g. due to low inflation, good rates of return on equity, large amounts of liquidity still sitting on the sidelines), despite the fact that so much remains highly uncertain.

All things considered, When, not If appears to be a good investment conclusion to reach at this time. And being a contrarian investor (as opposed to a follow the crowd momentum “investor”) means taking money off the table is a prudent course of action at this time. As the performance results to your left show, this has been a fruitful course of action to follow.

Comments

[waterlily57:]

Well written. I too am having the same observations and strategies. Opting for a recovery of paper losses and realization into solid cash might be wiser than chasing uncertain profits.

Sep 16 07:22 PM

[random guy:]

You prepare the same way that people were preparing for a correction when the S&P500 hit 800, 900 and 1000 -- foolheartedly.

The reality is, getting back up to 1050 (or more) *IS THE CORRECTION*.

Sep 16 10:13 PM

[dhansen548:]

A small pullback of 2 to four per cent would set the stage for a nice run to 1150 or more. After that, who knows-----at some point the truly dismal condition of Americans and their finances will make itself felt and the underlying bear market can resume. But all in good time, sometime next year.

Sep 16 10:32 PM

[gatrbz:]

Hey dudes......for those of you who don't remember what ended up happening when a bunch of over loaded global institutions didn't want to park their money in US bonds because rates were too low leading them to bang down Wall Street's door begging for a higher yield.....yeah that's right, the credit bubble. Guess what, its happening again. Except now, its the equity bubble.

Sep 17 12:58 AM

[johngonole:]

Nuts to the guy who thinks the increase is a correction. The first 2/3 of the upswing maybe. But we are closing in on DOW 10000. I remember when the DOW first crossed that number and the economy and its future outlook was much better than now.

Sep 17 02:08 AM

[adan:]

really nice article, thanks!

liked the correction scenarios, plus the "vision" used by those justifying a 15 or above p/e -

and especially liked your cautionary stance, thanks again....

Sep 17 08:46 AM

[David Van K...:]

Good strategy and well-reasoned outlook, but I think a better tactic to execute the strategy is to use trailing sell-stops. Why forego profits while the market is going up when you acknowledge that the timing of the next pullback is unpredictable? The market rally could go on for months. My exit strategy is to "wait for the turn," then let tight sell-stops get me out.

Sep 17 09:56 AM

[thiazole:]

The difference between long and short term capital gains is about 15% for me - there is no way I'm selling and taking short term capital gains right now unless I'm very confident that I will make more than that 15%. The risk of correction isn't large enough for me to take that chance. If I were to really get nervous, I might buy some broad market ETF puts to hedge my holdings. But I'm not going to get nervous until the Fed starts publicly worrying about the risk of inflation.

Sep 17 01:49 PM

[thiazole:]

I should point out, however, that it wouldn't surprise me at all if we DO get a correction starting later in September. I look for the formation of an "M" in the chart to be certain. One could say that we just had the first hump of the "M" - if it falls more tomorrow and/or Monday (forming the middle dip of the M), then goes back up and retests yesterday's close, then falls again, I would feel fairly sure that some kind of market correction will follow over the rest of October and maybe even into November.

Sep 17 04:54 PM