Correction Coming - Yes Or No?

 |  Includes: DIA, IVV, IWM, IWV, SPY
by: Todd Feldman

In previous articles we have written about how we believe we are in a 1986-1987 type cycle. Why do we believe this? We create our own behavioral measures to determine what kind of cycle the US stock market is in. We believe cycles repeat themselves because of the element of human behavior. If one can model human behavior well then they can pinpoint cycles. This is what we do.

In August of 2011 we witnessed something significant. We witnessed a change in our behavioral indicators for the US stock market that has only occurred four times since 1970. In all of those past fours periods there was a run up in stock prices in the range of 20-30%, a 10% pullback, 20% bounce back, and then a deeper correction all in the same time frame. We have witnessed the run up in stock prices from October 2011 to April 2012. We have witnessed the 10% pullback. We believe we are now in the bounce back phase of the cycle where stock prices may increase 20% from the intraday lows in June of 2012.

If we see a 15-20% bounce back from the intraday lows then we believe that a correction is imminent. Of the four periods to mimic the current cycle the 1986-1987 cycle is the closest. Below is the overlay between 2011-2012 and the 1986-1987 period for the S&P 500.

Figure 1: S&P 500 Overlay: 1986-1987 and 2011-2012

Click to enlarge

x-axis is the number of days. Benchmark at 100 when both were at lows in 1986 and 2011.

Now the similarity between the two periods is not perfect. We believe the cycle is on a slightly different path than in 1987, meaning the timing of the correction will be different. We initially believed that in September/October the US market would correct but based on the movement in our indicators we believe the timing may be somewhat later.

In conclusion, we believe a correction will take place, however, after the larger bounce back that we expect this summer. We recommend staying invested in US equity ETFs such as SPY, IWV, IWM, IVV, and DIA for at least the summer. Then to start selling.

Disclosure: I am long SPY.