How Big Would A "Real Correction" Likely Be?

August 27, 2014

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Over the last few days, my inbox has been overflowing with emails all asking the same question: “Is this THE correction?”

The actual answer is probably “NO” for a couple of very specific reasons. First, even though the Federal Reserve is tapering their purchases, they are still currently injecting $25 billion per month which flows directly into the financial markets. (For more on this issue read “Misunderstandings On The End Of QE”)

Secondly, full-fledged bear markets rarely happen when everyone is o the lookout for one. For example, here are just a few of the news articles over the last two days relating to this topic:

You get the idea. Regardless of whether you lean more towards the “bullish” or “bearish” persuasions there has been more than enough commentary as of late to satisfy both. Major market corrections tend to occur when they are least expected and are propelled by an unforeseen event that “panics” investors.

However, there is still a good question to be answered here.

“If this is the beginning of a more important, intermediate term, correction; how large could it be?”

As a portfolio strategist, this is the right question to ask. Why? My portfolio allocation models remain near fully invested. (I have been recommending in the weekly newsletter over the past several weeks to rebalance portfolios, to reduce risk, by trimming winners and selling laggards. These actions have raised cash levels as of late.) Therefore, what concerns me most is NOT what could cause the markets rise, as I am already invested, but what could lead to a sharp decline that would negatively impact investment capital.

[Important Note: It is worth remembering that winning the long-term investment game has more to do with avoidance of losses than the capturing of gains. It is a function of math.]

There is not just ONE answer to the question posed above. There are many factors that can, and will, contribute to the eventual correction. I am also not suggesting that an intermediate term correction has started, NOR am I predicting the timing of one. What I do want to explore with you today is the potential magnitude of a correction so that we can better understand the consequences to our portfolios of being misallocated at the turning point. (The following analysis is designed for a longer term perspective to identify risk/reward and potential changes in underlying trends.)

The first chart is a simple trend-line analysis of the weekly S&P 500 index.

As shown, the bull market trend that begin in 2009 remains currently intact (dashed blue line). A correction from current levels back to that bullish uptrend line, which occurred in both 2011 and 2012, would entail a decline to 1700. That would be a 14.6% decline from the recent intra-week market peak. While not technically a “bear” market, for many investors it will certainly “feel” like one.

However, in December of 2012, Ben Bernanke launched the latest round of monetary stimulus at a whopping $85 billion dollars a month. At that point, the markets elevated away from the previous bullish trend to establish a new trend (black dashed line). At the current time the intersection of that elevated bullish trend, which has repeatedly acted as support for the markets since the end of 2012, is at 1900. There is also some more minor support just below at 1850.

Currently, there seems to be nothing on the horizon to intensify the current “pullback” into a selling “panic.” Geopolitical events, weak underlying economic data, and extremely stretched market valuations have posed no immediate threat to the markets. This is clearly shown in the 6-month average of the Volatility (VIX) Index (a 6-month average is used to smooth the volatility of the volatility index.)

The 6-month average of the VIX is currently at the lowest levels of this century. Understand that it is NOT the decline in the VIX that is important, but rather the point at which the 6-month average turns higher. If you look at the chart you will see that 6-month average of the VIX turned, and begin to trend higher, just prior to the peaks of the market in 2000 and 2007. The same occurred in 2011 and 2012. Currently, the 6-month average of the VIX is still trending lower which suggests that the current correction, at this point, is just a pullback within the current uptrend. However, as you can see above, that can change very rapidly.

Should volatility begin to accelerate, this would be coincident with a much larger correction that would bring into focus the 2009 bullish trend line, as shown in the chart above. However, another way to look at potential corrections is to use a “Fibonacci Retracement” analysis as shown in the chart below. As defined by Investopedia:

“The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.”

As identified in the chart, the 23.6% retracement level basically confirms the 2009 bullish uptrend line around 1700 currently. If the market begins a more serious correction, this level should provide support for a short-term bounce that should be used to “sell” into to decrease equity risk in portfolios. The bounce from this support will most likely fail in short order. The markets will then either:

a) retest support at the bullish uptrend/23.6 retracement level and turn higher allowing equity risk to be increased, or;

b) that support will be violated, and the market will likely seek out the 38.2% retracement level at 1490.50. Such a decline would increase the magnitude of the correction to 25.14%. This would officially push the markets into “official” bear market territory.

While it is entirely possible, it is unlikely that (b) will happen outside of the onset of a recession. When the eventual “recession” does return to the economy, it is very likely that the markets could test the lower Fibonacci bands of 50% and 61.8% retracement levels.

The next chart is a “relative strength” and a “2-standard deviation” analysis of the weekly chart of the S&P 500. First, in the chart below, it is unusual for the markets to consistently push 2-standard deviations above the 50-week moving average for such a long period without a correction back to it. A correction back to the 50-week moving average at this point would entail a decline to 1829.31, a 8.12% decline from the recent peak.

Importantly, a decline to 2-standard deviations below the 50-week moving average would converge at the 1700 level, which as discussed above, is also home to the 2009 bullish trend line and the 23.6% retracement level.

The lower part of the chart is the “relative strength” index (RSI). This index has turned lower as of late with the recent correction and is currently posted a reading of 60. Levels of 80 represent “overbought” markets and levels below 40 represent periods of being “oversold.”

I have notated (vertical red lines) points at which the RSI had peaked and turned lower. Historically, the RSI tends to oscillate between 80 and 40 on the index. However, since the beginning of the latest round of Quantitative Easing (QE) by the Federal Reserve, the range has remained between 80 and 60. The same anomaly is shown in the next chart which is an analysis of the market relative to the Williams %R indicator.

The Williams %R indicator, like RSI is a representative of “overbought/oversold” conditions in the market by measuring changes in the momentum of prices over a specific period of time. From the beginning of 2009 to the end of 2012 (highlighted in gold), the index oscillated between levels of -20 or less, “overbought,” to -80 or greater, “oversold.” However, beginning in 2013 the oscillation has remained tightly constrained between ZERO and -30. This is unsustainable longer term and a break below the -30 level on the Williams %R will likely indicate a more severe deterioration in the markets.

There is no exact answer to the potential magnitude of a correction in the markets. “This” depends on “that” to occur, which is why trying predict markets more than a couple of days into the future is nothing more than a “wild ass guess” at best. However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes.

Currently, there is a convergence of points between 1650 and 1700 on the index that will present rather important levels of support for the market currently. Not only would a correction to such levels be a “healthy” event in order for the current “bull market” cycle to continue, it would also likely present a fairly decent opportunity to increase equity exposure in portfolios. As I noted above, a correction of 14-16% is far outside of the expectations of the market currently. Such an event will likely “feel” much worse to individuals that have inadvertently taken on excessive risk in their portfolios by “chasing” markets and “yield.”

However, while I show that the greater levels of a potential correction will likely be coincident with a recession, as they have historically been, it does NOT mean that a recession is required. A sharp rise in interest rates or inflation, a downturn in economic growth, deflationary pressures from the Eurozone, or a credit related issue in the “junk bond” market could all do the trick.

No one will know, until in hindsight, what the catalyst will be that ignites a “panic” in the market. This is why we do analysis to understand the potential risks in the market as compared to expected reward. What is abundantly clear is that the potential “upside” in the market is currently outweighed by the “downside” risk. It is important to remember that our job as investors is to “sell high” and “buy low.” Unfortunately, for most, it is exactly the opposite.

There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years. Hopefully, this won’t be you.