Corrections Come, Corrections Go

by: DAG Investments

So, despite the always-predictable rush of predictions that the world is ending, every correction does not equal a bear market. But, that doesn't necessarily mean that the pain is over either. What we are experiencing now is clearly more than a dip (<5%), but rather than split hairs about whether it's a full correction (>10%) or just a pullback (>5%), my goal is to offer readers some things to consider in either case.

Here I'll add to, and add some context to, comments I've been making in various places on SA in absence of time to write full articles. For example, comments here and here in my post 2013 Performance & 2014 Updates.

Note that, for each section below, the heading is really "my opinion of …"

What Is Not Happening

Despite the fact that we already had a full week of a soft market by the time I made this comment on January 9, and it has only gotten weaker since, I still believe that "the current secular bull market will continue throughout this entire year at least, if not for several more years." My point is that I believe we are indeed in a secular bull market, we're just having a healthy correction, and the secular bull market is not ending.

The following quote is from late December and is by one of the tier-one Wall Street investment strategists whose reports I regularly read:

"I read that, at 58 months, this rally is too long and can't continue. But, they are measuring it from the March 2009 "nominal low." We don't measure the 1982 to 2000 secular bull market from its "nominal low" of December 1974, but rather from its "valuation low" of August 1982. If we measure this bull move from its "valuation low" of October 2011, the current rally is 26 months long, not 58 months."

― Jeffrey Saut, Chief Investment Strategist, Raymond James

So, if historical patterns hold true, we're not even half way into the range that some consider the maximum that a single bull run within a secular bull market can last. In fact, the previous secular bull market Mr. Saut referred to lasted eighteen years and the first bull run within it lasted six.

That does not at all mean that the moves currently underway will last as long, but it does show that it's inaccurate to use the 2009 nominal bottom to claim that the bull has run too long and must stop. It's possible that a bear run within an overarching secular bull market may be starting, and it's possible that the bull market is indeed ending, but I don't believe either is the case. I think that, in order for either to occur, a "black swan" event would have to happen soon while the market is already weak.

What Is Happening

My belief is that we're merely experiencing a healthy market correction, that correction is not yet over, and it is part of the process of returning to a more normal market environment. What I mean by that last part is that 2013 was far from normal in that the market went practically straight up. As I commented on January 9, I believe "volatility is back for 2014" and it is here to stay. However, volatility is not a bad thing.

"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever."

― Nassim Nicholas Taleb (originator of the term "black swan")

While it's true that volatility is even better for short-term traders, it's also good for investors since only volatility can create buying opportunities. I'm not a sell-the-tops type investor who constantly trades in and out of entire positions, but I still need buying opportunities since I always scale into positions and I also trade around some core positions. I've detailed both tactics in an Instablog and, while I don't suggest position trading for most investors, I strongly suggest scaling for all investors.

The return of volatility makes it harder to tell when market weakness is subsiding, but the high likelihood that the current correction isn't over yet is the most important thing to know about what is happening now. Before I go on, note that I wrote this on February 4 after all three indices closed up significantly. While I'm not in the business of calling short-term moves in the market or stocks, it's important that investors not assume the sell-off is over and buy too much too soon. When I've commented that I'm "getting my buy list ready," that does not mean I'm buying yet.

I believe Tuesday's respite was likely just a relief rally. The general reason I believe that is, as detailed in the next sections, most of the market weakness results from sentiment about things that might happen, rather than events that have already happened. That tends to make it harder for the market to find a definitive direction. The next two sections cover specific reasons I believe the correction isn't over.

Why It Is Happening

There are too many factors contributing to the market weakness to cover them all here so I'll just touch on the big ones from the past few weeks to give a sense of what to watch for over the coming weeks and months. Each factor is macro-economic and I don't profess to be an economist but, as an investor who has successfully traversed many corrections, perhaps I can offer some perspective that will help other investors.

Fears about China contribute to the current market turbulence in the U.S. since we do live in a global economy, after all. A couple weeks ago, weak Purchasing Manager Index [PMI] data from China rekindled fears that economic growth may continue slowing to a point that weighs down all economies worldwide. That would be the "hard landing" scenario that we all heard about on a daily basis during the first half of 2013.

The China fear is exacerbated by talk that the nation has considered letting one of its non-guaranteed bank deposit products go bankrupt. Even though the Wealth Management Product [WMP] at risk only holds $496M, letting it fail would set a precedent that could cause loss of confidence in all WMPs and result in a bank run. This issue has been called a potential "Lehman Moment" for China.

Both of those possible issues with the Chinese economy would have very real effects on U.S. markets so I'm certainly not making light of them. At the same time, I don't believe that these issues represent a reason to exit good investments. First, investors (as opposed to traders) have long enough time horizons that we need not run for the exits at every hint of possible economic risk. There are always such risks. Furthermore, many companies don't do much business in China so their earnings aren't decided by the price of tea in China, so to speak. Perhaps investors might keep an eye on the potential issues in China, but need not overreact.

Just as U.S. markets were starting to come to that realization, indicators that our own economy has slowed kicked in to pull the market down more. Similar to China, the culprit was the report this past Monday of a weaker than expected PMI number. While much of the soft PMI is attributable to the extreme weather conditions impacting many industries, the concern is that the next PMI report will be weak for the same reason. Again, such a possibility may be a deciding factor for short-term traders who only have time horizons of a few weeks or months, but such fluctuations actually create buying opportunities for investors.

Finally, emerging markets issues are affecting stock markets worldwide, with huge amounts of money exiting emerging markets and already-weak currencies dropping like rocks. A significant portion of global demand is from emerging markets so the problems are important, but the currency devaluing is largely a policy issue, which makes it manageable over the longer term that should matter to investors.

What Now

As mentioned in a couple of my (admittedly, poorly-titled) articles, Ralph Acampora is one of the technicians that I've followed for years and whose opinions I trust most. Monday morning, Mr. Acampora commented:

"No signs evident yet that we made an important market low … be prepared for more weakness."

― Ralph Acampora, CMT, Director of Technical Research

Altaira Wealth Management

Mr. Acampora was exactly right since Monday turned out to be a truly ugly day. My view is that, despite the potential for a continued relief rally Wednesday or Thursday, the next big thing to decide market direction is the nonfarm payroll number on Friday (2/7). A second weak number in a row would likely cause the market to give back any gains from the relief rallies, and then some. However, Goldman Sachs has offered reasons to believe that the nonfarm payroll number will be strong.

If we do get a decent payroll number, we're not out of the woods just yet since some members of Congress are apparently planning to hold the debt ceiling hostage again. If we get a bad nonfarm payroll number and the debt ceiling is not raised, look out below. The former would be enough to practically guarantee a more severe correction and both at the same time would not be pleasant. Unlike when we had the last government shutdown not long ago, the market is already weak right now. The good news is that our elected officials know exactly what the impact on the economy would be so, hopefully, they're smart enough to avoid the aforementioned scenario. We should find out this Friday (2/7).

Due to the lingering issues mentioned above, and the more immediate issues mentioned in this section, we remain in what many traders call a "risk-off" market for the near term. As an investor, I dislike the terms "risk-on" and "risk-off" because they imply that risk management is a simple switch to be flicked on or off, but the terms do help convey some points more succinctly. For example, it's important to know that small-cap growth stocks tend to get hit in risk-off scenarios. That doesn't mean a stock is broken so, if you "know what you own, and why you own it," don't get spooked too easily and sell bottoms, instead of buy bottoms.

Despite all of the possible negatives that I've touched on that could send the market even lower, my opinion of what to expect for 2014 as a whole has not changed and remains positive. I don't subscribe to the idea that the entire year will be bad because January was not good. Even though the "January Barometer" states that the January market direction foretells market direction for the year and that does have somewhat accurate record, perhaps this January is an exception for reasons touched on toward the end of my article: 2013 Performance & 2014 Updates.

Final Thoughts

Related to that last point, I'm writing this article to reaffirm that, just like the discipline I suggest to other investors, I don't change my whole game plan each time the market dips. So, I'm not lowering price targets due to current market weakness. Instead, I've tried to clarify the reasons I don't believe that's necessary. Some of the stocks I recommend have dipped lower than my buy prices, but that happens sometimes since corrections take stocks lower than justifiable by any valuation method. I only hope that investors remember to buy into weakness, not sell into weakness, which is one reason I recommend always scaling in. My hope is that investors are prepared to add to holdings when the return of volatility brings corrections, and also remember that call timelines are just as important as price targets. Patience is key.

Stocks don't necessarily bottom at the same times so, when adding to existing positions, consider balancing the risk of adding too early and missing opportunities. I do that by splitting my buys into pieces, similar to when I'm scaling into new positions. For example, if I add too early and the stock continues down, I can add 2-3 more times, rather than try to call the bottom for each stock exactly accurately. Just as when opening a new position, the worst case scenario is that I don't add enough before the dip ends and I have to wait until the next one to buy again.

As I commented a week ago, I've been "getting my buy list ready to add to Aceto (NASDAQ:ACET), Blackstone (NYSE:BX), General Electric (NYSE:GE), HCI Group (NYSE:HCI), Manitowoc (NYSE:MTW), Valero (NYSE:VLO). Of course, the one I want to buy most is barely down: InterContinental Hotels (NYSE:IHG). That doesn't mean I like IHG better than the others. It's just one that ran up before I bought enough."

Perficient (NASDAQ:PRFT) is one that I forgot to include, but I'll be adding to that position soon too. In fact, I consider it one of my most undervalued calls so I find it ironic that it's also my least-read article. In that and other ways, it's similar to ACET, which was also my least read article, until after its >54% run, of course. My Anacor (NASDAQ:ANAC) short-term opportunity article was barely read too, until after its >42% run in five weeks, of course.

I'm still trying to make time to write update articles to raise price targets on many of my calls. In the meantime, just ask if you want to discuss any of them before I post a new article.

And, keep calm and carry on ... corrections come and corrections go.

Thank you for reading. I wrote this article 2/3-2/4.

Disclosure: I am long ACET, BX, GE, HCI, IHG, MTW, PRFT, VLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long ACET, BX, GE, HCI, IHG, MTW, PRFT and VLO; and may buy additional shares at any time.