five signs a small correction could get bigger
Investors have seemed quite concerned in the past few weeks, especially after tasting their first market correction in some time.
The selloff was, in the grand scheme of things, quite minor. But world markets have been so strong for so long that watching the TSX drop 200 points recently likely made many investors think a big selloff was about to occur. It is coming up to October, after all.
With that in mind, here are five factors to watch for signs that a small correction might be heading toward a large correction or worse. This is hardly scientific, but we have experienced plenty of corrections over the years, and most of these signs are worth noting, if they do start to occur.
Volume Generally, the more volume in a selloff, the more concerned you should be. The thesis is that there are plenty of investors selling when trading volumes are large and they are quite happy moving lots of stock at lower prices, preferring, perhaps, just to hold cash.
Of course, for every seller there is a buyer, but if large selling continues, then buyers get antsy, or simply run out of buying power, which can accelerate a market decline and turn a small correction into a large one.
Block trades If, in a market decline, you see a dramatic increase in block trading, it means that institutions are more than happy to sell into the decline.
This is not necessarily really bad, because, of course, it is usually institutions buying on the other side. However, it might mean that institutions (particularly mutual funds) need to raise cash to fund redemptions.
If that is the case, then a market decline can continue for some time if investors en masse are pulling funds out of the market. Watching block-trading volume can be a clue to this activity.
Gaps Watch for stocks that trade dramatically lower, or gap down, which can be a very negative sign because it means there are desperate sellers.
In this case, a seller wants or needs to sell, and there aren’t any buyers immediately available, so the seller needs to trade at whatever price the buyers want just to execute a trade.
This price might be several dollars lower than the last trade. This is bad in many ways, because a gap often causes panic and more selling, or simply triggers outstanding stop-loss orders, also resulting in more selling.
Decline type A decline that is isolated to one or two sectors is generally far less worrying than a broad market selloff.
In the TSX’s recent declines, for example, it was largely the energy sector initially, and then, earlier this week, pipelines and financials took a hit. But some sectors did just fine.
A sector selloff may just mean profit taking (that’s likely the case with energy) or simple sector rotation amongst institutional investors.
Far more worrying is a broad market selloff, where investors are quite willing to sell everything. A broad selloff can imply investors are leaving the market, rather than redeploying capital. It could be a sign of early fear, which can feed upon itself.
Fundamentals Investors often sell just because other investors are selling, with total disregard for the fundamentals. It is very important, though, to remember that, in the long term, fundamentals (earnings, the economy and interest rates) will override these shortterm movements.
If the company whose stock you own is doing well, growing, well-managed and has a good balance sheet, there is no need to panic if it declines a bit in the short term. The very best stocks in the world can go down, a lot, and, often, in the short term.
If there is a correction in the market, but you strongly believe in the fundamentals of the economy and your companies, we would simply ignore it.
Of course, these signs can often be false market signals, so we would not base any sort of trading strategy around them. Every single major correction in market history started with a small correction first, so being wrong and buying too early could still have devastating results on your portfolio.
Although there are no guarantees in the market, we are not particularly concerned about the recent selloff.