Take a profit before market corrects

There may be fewer bulls out there, but it seems as though the ones who have left the camp have merely moved to the fence as opposed to being outright bearish — in other words, the “buy the dip” mentality has become very well ingrained. Maybe too much so.

The Investor’s Intelligence poll released August 5 showed the bull camp has dropped five points to 50.5% from 55.6%, and is now 12 points off the mid-June peak that basically predicted the weakness in the market we have seen of late.

The current level is still lofty, but it is actually the lowest level of exuberance we have seen since mid-April (when the S&P 500 was sitting at 1,840, mind you). The bear camp did not move that much, up to 17.1% from 16.2%, but bang in line with the mid-point of the 15%to-20% range so far this year.

At the same time, the correction camp jumped to 32.4% from 28.2% to stand at a sixmonth high. The problem — as

Technical picture has been damaged ... and valuations are stretched

we have seen time and time again — is that the more the masses believe we will get a correction, the greater are the odds that it will not materialize.

Be that as it may, the technical picture has been damaged, both volumes and breadth have been weak, and valuations are stretched. Not to mention the rarity of going three years without a meaningful cleansing. The fact that there is so much uncertainty now regarding the U.S. Federal Reserve and the tense global geopolitical situation are reasons enough to mean-revert the market multiple.

Since 1960, the S&P 500 has had no fewer than 13 nonrecessionary corrections of at least 10%. The median length of these corrective phases is 101 days (the average is 144) and the median decline is 14.4% (average is -16.1%).

What is interesting is that more often than not (11 of the 13 episodes), earnings growth is generally stellar in these correction periods. In some cases — like the fourth quarter of 1987, which included the steepest one-day plunge since 1929 — reported profits were up more than 50% on a year-overyear basis. On average, in these corrective phases, earnings are not just positive but up by more than 20%.

And so when we hear the comment, “But why should the market correct? Look at how good the corporate earnings season proved to be,” the response is that we can and do get corrections even if profit growth is strong when there are overbought conditions coupled with excessive valuations to deal with as a shock or series of shocks set in. In this case, we have a policy regime shift at the Fed (only timing is the issue), a tense geopolitical situation, and shocking weakness in the recent euro area data flow.

Remember, 10% corrections in a bull market when profits are growing and a recession is not in sight are brief affairs, typically lasting three months. But they do occur. Liquidity, sentiment, technicals, market positioning and fund flows can often generate periodic setbacks of this magnitude even in the face of solid profit fundamentals. They are not permanent situations and are not recessionary bear markets, which tend to last two years and see the market go down well over 30%.

Of course, investors could try to avoid the corrections, understanding that nobody is that perfect as to time the market perfectly. That said, in the name of building the proverbial straw man, a little history can go a long way.

Managing to avoid the summertime 2011 correction, as an example, would have meant locking in a 9% gain for the year before the clouds rolled in, instead of being flat on the year by being passive with the portfolio.

In 1998, unemployment had a “4-handle,” real GDP growth had a “5-handle,” and nominal growth had a “6-handle” — you could not have drawn up a more bullish economic backdrop — but that did not stop an overvalued market from succumbing to the intensifying financial pressures coming out of the Asian crisis. If you managed to find the will to protect the portfolio ahead of and during the corrective phase that summer and fall, you would have avoided a 20% hit.

Getting out near the 1987 peak and not waiting around for that mother-of-all corrections would have meant, with 100% hindsight, locking in a 36% profit instead of, again, waiting it out and being flat on the year. Some food for thought (as an aside, by no means is this 1987).

It may not be that clear that we have entered a true corrective phase of 10%, but there are enough smoking guns around to suggest that such is not a trivial prospect. If it is the case, taking out some insurance without actually having to abandon positions is not altogether a bad idea. In fact, it is probably a very prudent thing to do.