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Tuesday afternoon CNBC's Street Talk featured two analysts discussing the prospects of a market correction.  The topic is both timely and important.  The participants were analysts using two different methodologies.  This is the kind of segment that has us getting some popcorn and pulling up our chairs.

Hosting the segment was Erin Burnett, whose star is rapidly rising at CNBC.  Her strong educational and work background helps her to be a good interviewer.

What Happened

The first to speak of her two guests was Mark Arbeter, chief technical strategist at S&P.  He explained that he had developed a system to predict market corrections.  He looks for Nasdaq volume 40% higher than the NYSE over a three-week period.  It has provided signals in 2004, 2005, and 2006.

The second guest was Paul Hickey, an analyst at Birinyi Associates.  While acknowledging that there was always the chance of a correction, he put the odds at no greater or worse than at any other time.  Hickey noted that conclusions about the current bull market were often erroneous because the increase in stock prices has been far more gentle than in past cycles.

Erin gave Arbeter a chance to reply.  He acknowledged that he was bullish on the year as a whole, but thought there were be a better opportunity to buy in March or April.

So far so good, but now Erin slipped in one last question to make things more interesting.  She asked if Mark saw a chance, not of a correction of eight percent or so, but the possibility of a crash like that of 1987 (where there was a one-day decline of 23%).  She asked this question (we suppose) partly because experts on corrections might know about crashes.  It might also have been because Jim Paulsen of Wells Capital Management, a frequent CNBC guest, has recently been suggesting this possibility.

Two Bad Things Happen

The first bad thing to happen was that Mark Arbeter answered the question without offering any warning to the viewer.  He responded that if the market did not correct as he was predicting, it might lead to something worse later in the year.

The problem is that Mark Arbeter had exceeded his expert status, something we have warned about.  Even if one accepts his system for predicting corrections (more on that in a minute), he has no evidence that the lack of a correction will lead to a crash.  He should have said, "That is Not My Job."  It must be difficult to say that when Erin asks one more question.

Anyone following Arbeter's advice must first wait out his prediction --70% chance of a correction by April.  Then, if he was wrong, the investor should be even more afraid of a big decline.  And this is from an analyst who says he is bullish on the year!

The second bad thing is the result of the new CNBC web site.  We are enjoying the ability to go back and replay video segments that we missed.  It is also handy to have a summary of the segment in text form, a speedier way to get the message.  If the story looks interesting, the video is there for more detail.  The problem is that the text segment (at least at the time of this writing) has a big mistake.  It reports as follows:

U.S. Treasury Secretary Henry Paulson has said that he’s expecting a crash on the scale seen in October 1987. Arbeter does see potential for that to happen, which is why he’s hoping the market corrects now rather than building the entire year and then making a major adjustment in the third or fourth quarters.

“I would be worried if we didn’t get the correction now, early in the year,” Arbeter says.

This had us checking the video, to see if we had missed some big story.  Erin clearly says "Jim Paulsen" not "Hank Paulson".  If the former Goldman CEO and current Treasury Secretary predicted a market crash, it would be big news.  There is no obvious way to notify CNBC of this error, or we would do so.  Meanwhile, anyone reading the summary could make a big financial mistake.

And Finally, the Debate

It is difficult to evaluate a system for predicting corrections without looking at the data, but Arbeter's system sounds a number of warning bells:

  • He describes his three recent accurate forecasts.  We like to see a much longer time period.  Surely there are some "false positives" as well as accurate calls if one looks further back.  The on-screen graphic said "seventy percent."
  • How has he tested the parameters?  For example, what is defined as a correction?  How did he arrive at 40% as the Nasdaq/NYSE volume difference.  What if it were only 37%?
  • How does he determine the length of time before a correction will occur?

Our experience with such systems is that by playing around with the values for a few variables it is easily possible to find something that seems to explain some past corrections.  A system developed in that way has questionable predictive power.

One very obvious point is that tech stocks have lagged the market during the current rally.  Would it be so surprising to see those sectors catch up for a bit?  Wouldn't Nasdaq volume gain if that happened?  What if the Vista launch does stimulate a new equipment buying cycle?

By contrast, we find Paul Hickey's conclusions to be quite sound.  There is certainly a chance for a correction, but our research shows that market bottoms are easier to identify than tops.

In particular, we recommend that our readers pay close attention to Hickey's careful job of distinguishing this bull market from past cycles, something we have also tried to demonstrate.

Conclusion

How stories are communicated may prove to be just as important as the story itself.  MSM web sites do not offer the same potential for instant correction as there is for an investment blog.  Maybe the medium is the message.

Source: CNBC Market Correction Story: How To Correct The Errors?