Section III: Correction
15 Correction
Market
timing has been judged wrongly by many. Just check out how the two major
plunges can be detected easily by my simple chart.
Corrections
are harder to detect. So far, I have more rights than wrongs in detecting
corrections.
Everyone
has its own definition of a correction and mine is as follows. A correction is
a 10% or more down from the peak of the last 180 days or more than 5% down in a
month. Sometimes, corrections continue to 20% loss. My definition of a market
plunge is the loss of 40% or more from the recent peak to the bottom. There is
a gray area between a 20% to 40% loss.
From
my definition, there is no correction in 2013 and that is quite rare. On the
average it happens at least once every year since 2000 depending on my
interpretation. I also estimate two minor corrections of 5% every year if we do
not have a 10% correction.
Corrections
provide us opportunities to enter the market. Temporary peaks provide us
opportunities to sell. They happen about one to two times a year on the average
but their frequencies fluctuate widely. I usually start selling at the expected
peaks, and buying at the expected bottoms. Your cash position depends on your
risk tolerance. ‘Buy-and-hold’ investors can just ignore corrections and this
chapter.
Some
hints (not always reliable) predict the temporary market peak:
·
Up more than 10% of the expected gain. To
illustrate, you predicted this year’s total return is 12% in the beginning of
the year. In March, the market has already gained 12%, there is a good chance
it is close to the yearly peak and you should act accordingly. Review the
stocks you own and sell those with less appreciation potential first.
·
The market exceeds a good percent over the last
peak. Define this percent based on your risk tolerance.
·
Compare the annualized market P/E (SPY or any
market index ETF) to its 5-year average (10-year average is fine too).
·
Foreign markets are down and ours are up by a
good margin.
·
The interest rate. When it rises, the market
will be down.
·
It happens more than three consecutive days that
there are more stocks advancing than retreating.
·
It happens more than three consecutive days that
the number of new highs is more than the number of new lows.
·
From Finviz.com, SPY’s SMA200 exceeds 10% (=
(Price – SMA)/SMA). SMA-200 is Single Moving Average for the last 200 sessions.
It indicates it may be temporarily peaking. Use it for reference only as it is
not always reliable.
·
From Finviz.com, SPY’s RSI(14), the relative
strength index based on the last 14 days, exceeds 55%. It indicates that it may
be overbought. This is for reference only as it is not always reliable.
·
There are always reasons for corrections such as
the market is overvalued, rising interest rates, degrading corporation earnings
and trade wars.
Conclusion
Corrections
are harder to detect in comparing to the market plunges which we have excellent
results so far from 2000.
Do
not bet the entire farm on corrections especially when the market is risky.
Keep less than 25% of your portfolio in cash on the expected peaks.
When
the market corrects, it is a buying opportunity. However, when the market
starts to plunge, we should exit the market as the losses could be high. If all
the conditions in the following table are exceeded, most likely the market is
peaking. One’s opinion.
|
SMA-50%
|
SMA-200%
|
SMA-350%
|
Avg. of the 3 the SMA%
|
RSI(14)
|
|
4%
|
6%
|
11%
|
9%
|
65%
|
16 Six signs of a correction
Six signs of a
correction:
1.
All
my technical indicators show the market is peaking and overbought. SPY is an ETF simulating
the market of the S&P 500 stocks. As of 6/29/2014, the RSI(14) is at 67%
and the SMA-200% is at 8.35%. SMA-200% measures how far away the stock price is
from its simple moving average of the last 200 trade sessions.
You may argue that you do not believe in technical analysis.
However, many institutional fund managers learn technical analysis and they
will act accordingly. It is one of the many tools that hedge fund managers use
to ‘hedge’. Most mutual fund managers cannot practice market timing bound by
the rules and regulations.
2.
Newton's
Law of Gravity has never been proven wrong (some humor to get your attention).
What goes up must come down. The market has been up even after inflation.
However, it takes a breather from time to time. A small one is called a
correction and a big one is called a market plunge.
3.
We
did not have one such correction of 10% in 2013, so the time is ripe. The
average is about one correction of 10% or more and about 1.5 corrections for 5%
in a year. Many experts predicted wrongly on a correction in 2013. I do not bet
against them to be wrong two times in a row.
4. There are more articles
predicting a correction than articles arguing against it. It could be a
self-fulfilling prophesy. It is the herd psychology. One’s opinion.
5.
The
market has low volumes and narrow ranges for many days may indicate that the market
is changing direction. The sea is calmest before a storm.
6.
I
am not convinced that I can make a lot of profit even if there is no
correction. To me, the market is fully valued. It is my reward / risk ratio. I
prefer not to make the last buck and have a good sleep.
How to protect
yourself
It depends on your risk
tolerance.
1.
Accumulate
cash from 0% to 50%. I recommend 15% for most. 0% is for those who ignore the signs. It
was a great selection for 2013. I select 50% as I'm more conservative than
most.
2.
Place
stop orders. Adjust them when they appreciate. Some stocks are more volatile
than others. I prefer to use stop orders in market plunges rather than
corrections, as corrections are too brief to be effective.
3.
Short
the market. I do not recommend shorting in most cases. Buying a contra ETF may help.
In any case, do not risk money you cannot afford to lose.
4.
Use
options to protect your portfolio.
5.
Prepare
a list of stocks to buy when there is a correction, and wait for better time to
invest.
Do not
treat my (or all others') predictions as gospel. Predictions are just
predictions. It is like buying insurance that we do not expect to collect from.
I have to admit market timing is not an exact science.
Hopefully we are more right than wrong.
Summary of comments
on the article
There are two camps: one who
believe and one who do not believe. It is as expected. I will not take credit
if there will be a correction within a month, or take the blame if there will
be none in the next 3 months. From my record, I have more right than wrong
predictions, but it may have nothing to do with future market predictions. Here
is my summary:
1. I
did think of other signs as mentioned by some of my readers: interest rate, oil
price, current events… I expect interest rates will start rising by the end of
the year. The recent rise in oil price is due to the turmoil in the Middle
East. The current events including Ukraine and the Middle East seem not to be a
factor as our leader does not want to participate in this.
2. I
do not expect a market plunge (over 30% down) as I do not see any bubbles
(those bubble stocks are too few). My prediction: These bubble stocks will be
half the peaks achieved in 2013 and 2014 by the end of 2014. To me, all stock
trades are predictions. Some materialize and some do not.
3. Corrections
are harder to detect than market plunges. After I detect a plunge, I will spend
most of my time in protecting my portfolio.
##Fillers:
# Where common sense is not common sense
Excessive printing of money is
not a long-term solution. Servicing the huge debt weakens our competitiveness.
The politicians just want to buy votes today and finance their campaigns. Our
next generations will have to pay for these huge debts.
I have never taken any business
classes unless required for my engineering degrees and yet I can understand it
via common sense. I wonder why our highly-educated (at least by their Ph.D.
certificates), smartly-looking (looks could be deceiving), high salaried (many
times higher than mine) decision makers do not understand and act on it.
# On Shooting and any violence.
“Forgive” is the most powerful word in any language in any culture. “Pray for
the victims” do not do any good, but take actions to prevent similar shootings
from happening. PLEASE.
# Why fillers? A blank page space
is too much to waste. Most if not all of the fillers are created by me.
# Consumption vs. Investing. We
consume more than we produce (causing deficits) and investing much less
(causing our downfall).
# Teach the able welfare
recipients how to fish instead of giving them fish for the rest of their lives.
They will not work if you take out their welfare benefits for working.
17 Anticipating a correction
‘Buy-and-hold’ investors can ignore this chapter. This
chapter enhances the last one.
You should try to sell as many
stocks as you own before the correction comes and buy them back during and
after the expected correction. It does not always work. However, it is good to
churn your portfolio to ensure it has better appreciation potential at the
expense of capital gain taxes in non-retirement accounts.
Signs of a market top
(same as correction is coming)
·
The market has been up for over 4 months from
the last dip.
·
The market has gained more than the predicted
share.
·
If most of your stocks are at the peak, take
some profits.
·
Use Technical Analysis (via use of charts) as
below.
Here is
one of the charts that could predict temporary market dips and surges. Buy when
the price is above the SMA (simple moving average) and sell when it is below.
This example uses 50 days for SMA for 2012. SMA-50% is also available from Finviz.com.
Vary
the number of days and/or use other indicators to reduce noise or improve the
trading frequency to fit your individual needs.
Source: Yahoo!Finance.
If you are
reading this book on small screen and cannot see the chart, type the following
into your browser.
There are too
many trades in the above chart especially in the month of April. The period from July 1 to Oct. 15 is a good
capture of the upward trend. It is useful but not perfect. Try to use SMA-100
instead of the above SMA-50.
Example of a market top
The following is from my blog
written on May 19, 2011 and it turned out to be quite accurate. Check why I
expected a correction would be coming. Hopefully we can spot the next one with
similar reasoning. However, there is no guarantee for future performance and
predictions.
Click here on the actual
blog and the summary follows.
As of May 19, 2011, the market had been up by about 9% YTD.
The experts were divided whether the market would take a correction with
convincing arguments for and against.
I had been selling stocks several weeks before and moved most of my Annuity positions to a money market fund. My total cash was 25% and I was still selling. I tried to sell most of my stocks at 5 to 10% higher than the market prices. Hence, even if there were no correction, I was still selling far better than my current prices and it was a reasonable insurance policy. I predicted that the market was risky at that time; you have to trust your prediction and act accordingly as it did.
After I had accumulated more than 30% in cash, I played the 'Buy one and Sell two’ strategy betting I could spot stocks better than others. I tried to sell the stocks I bought right away for a small profit as I still expected a correction.
* Arguments for no correction:
I had been selling stocks several weeks before and moved most of my Annuity positions to a money market fund. My total cash was 25% and I was still selling. I tried to sell most of my stocks at 5 to 10% higher than the market prices. Hence, even if there were no correction, I was still selling far better than my current prices and it was a reasonable insurance policy. I predicted that the market was risky at that time; you have to trust your prediction and act accordingly as it did.
After I had accumulated more than 30% in cash, I played the 'Buy one and Sell two’ strategy betting I could spot stocks better than others. I tried to sell the stocks I bought right away for a small profit as I still expected a correction.
* Arguments for no correction:
·
QE3 would be materialized (even it will not
amount to a lot of cash due to the debt ceiling).
·
Corporate profits are still rising.
·
The economy is improving.
*
Arguments for correction:
·
QE3 will not be materialized and no money will
be used to stimulate the economy.
·
The market is taking a breather after 9% YTD (I
expect 5% rise in mid-year).
·
Slim chance for the rule 'Stay away in May' as
it had not been working for the two consecutive years except in today’s
extended bull market.
·
There are financial problems from China, EU,
Japan and N. Africa.
·
With tightening margin requirements on commodities,
oil..., speculative trades will be reduced (good for the long term).
The above is a summary of what the experts said. I did not do any research (as it is already available from the web). I summarized their opinions, selected what made sense to me, and acted accordingly.
I chose the middle road by not taking extreme actions such as selling all my holdings and heavily investing in contra ETFs.
Afterthoughts
·
My Elastic Band Theory.
The more you
stretch an elastic band, the more it will rebound. When a stock’s timing score
is 10 (the best), it has no way to go but down. That is similar to the general
market.
The risk/award ratio is too high as of 4/2013. Unless you have a time machine, you may not want to make the last buck.
The risk/award ratio is too high as of 4/2013. Unless you have a time machine, you may not want to make the last buck.
·
A related article
from SA.
Links
Original blog:
An article
on preparing for a correction. http://www.forbes.com/sites/investor/2014/05/19/five-things-to-do-in-a-stock-market-correction/
18 Market correction in August, 2015
I have 50% in cash before the August correction. I should have 100% if I
followed my chart. However, we are just human beings blinded by our greed /
fears and emotional attachment.
|
Stocks
|
Buy Price
|
Buy Date
|
Return
|
Sold date
|
|
Apple (AAPL)
|
107.20
|
08/26/15
|
12%
|
10/19/15
|
|
Gilead Sciences (GILD)
|
105.94
|
08/26/15
|
-4%
|
|
|
General Motors (GM)
|
27.69
|
08/26/15
|
12%
|
09/17/15
|
|
Genwealth Financial
(GNW)
|
4.54
|
08/26/15
|
10%
|
08/27/15
|
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