Of Corrections, Comebacks and Cognitive Dissonance

Growth and decline are the market breathing, inhaling when it advances and exhaling when it declines.

If you mention the C-word (correction) these days, the likely response will be: “What on earth could cause a correction in this market, especially given the improving economic and pandemic news?”

The perennial answer is: Something unforeseeable, as the foreseeable is baked in.

All corrections come out of the blue. Corrections (an overall decline of the market of at least 10% from its most recent peak) and pullbacks of more than five percent are endemic to the market. Growth and decline are the market breathing, inhaling when it advances and exhaling when it declines.

Since 2008, there have been 16 pullbacks of more than 5%—on average, about one every nine months. During this period, there have been several multi-year periods without a pullback.

To make hay during those periods, buying on minor dips was especially important because these were some of the best value-purchase opportunities.

Using our imaginations, a correction or pullback could come from: new coronavirus variants completely unfazed by existing vaccines, the Fed’s hinting that inflation is heating up significantly and Wall Street’s concluding that interest rates will rise sharply, trade pressure from China, or wars breaking out.

And there’s an infinite flock of black swans: a big junk-bond-supported company declaring bankruptcy, the sudden death of President Joe Biden, a flash crash (like the one in 2010) that triggers institutional trading algorithms and sends the market spiraling downward, or you-name-it.

With all the speculation about potential downturns these days, a natural subject when the market is moving upward, one possible cause would be herd selling triggered purely by investors’ fears of other investors’ fear-driven behavior—fear of fear itself.

A skinny V

The good news is that the same conditions that prompt skepticism over whether a correction may be imminent will likely make the next one short-lived, likely causing a bounce at an angle even more acute than last spring’s rebound from the March COVID crash. 

Federal stimulus, the decline of the pandemic thus far, vaccinations, nascent economic recovery, historically astronomical market liquidity and high pandemic savings ready for investment are all poised to promptly push equities back up. 

That’s why those who are using the words “froth,” “overbought” and “inflated” aren’t uttering the B word—bear market. The market promptly bounced back last spring despite the uncertainty over when vaccines would be available.

All these factors would make a substantial pullback or correction an ideal buying opportunity. For this day, it’s good to have some cash ready--in your brokerage account, for rapid deployment--and a list of stocks that could quickly become more attractive before they rise again.

A common source of anxiety over the potential for corrections is interest rates and inflation potential. Financial media commentators engage in almost constant hair-pulling on the subject, mentioning the 10-year Treasury yield like the devil at a revival.

But as interest rates are so historically low, small rate rises aren’t really a problem. And the current scenario of a steeping yield curve, with the spread between long-term and short-term Treasury yields widening, is a sign of economic growth that’s likely to benefit the market.

Interest rate obsession

Granted, if short-term rates started rapidly moving a lot higher due to inflation, that could be a problem. But short of that, the current rate scenario bodes well for stocks.

Worry over the market getting dinged anytime soon by interest-rate metrics is actually so much cognitive dissonance, as these factors actually reflect a good economy—ironically, the kind these same investors want because it propels stock prices.

Underlying the bond-yield obsession is the question: Won’t higher yields make bonds more attractive compared to risk assets (aka stocks)?

Given the ridiculously low current fixed-income yields and the continuing opportunities for equity gains, that’s quite a stretch, considering that the resourceful can find various income-producing alternatives to bonds with far higher yields and generally lower risk than stocks.

For those trying to read the tea leaves for a potential market pullback, one method is to watch for changes in investing trends of big money by tracking it routinely.

About 90% of all trading is institutional, but too many investors are unaware of meaningful patterns unless there’s a crash and then they look back at what happened; the idea is to see it coming. 

Most individuals understand what happens in a downturn when big institutional algorithms kick in. What they’re less aware of, however, is the big boys’ trading patterns over time and what directional changes may portend for the market.

The day-to-day trading patterns of big hedge funds, sovereign wealth funds, banks and other mega-traders tend to signal where the market is likely to go. Once these whales start to migrate, nothing else matters—neither fundamentals, nor individual investor sentiment, nor media articles.

The firm Mapsignals.com has developed ways of tracking these mammals’ movements to pinpoint when their trading patterns start to shift, signaling an incipient market pullback. Currently, according to their tracking, a potential pullback pattern is forming, but still may be weeks away. 

Of course, these analysts are professionals with specialized tools unavailable to the individual investor. But enterprising individuals may be able to develop their own, big-money rosters and spot-check their trading patterns regularly to look for shifts.

As corrections are relative to recent peaks, the questions of whether a correction is imminent and whether we’re at a bull market top might be viewed as basically one and the same. 

Strong bovine legs

The analysis firm Strategas Research Partners keeps a checklist of conditions indicating a significant market top.

Of the nine indicators—conditions that preceded the market drops in 2000 and 2007—only two were present in mid-February: the S&P 500’s being well above its 200-day moving average—by 15%; and a recent increase IPO activity.

Yet current conditions regarding the other Strategas market-top indicators suggest that this bull still has energy aplenty: the absence of big ETF inflows (this is a stock-picker’s market), rising real interest rates (not happening), weakening upward earnings revisions (these remain a historically high), fewer stocks hitting new highs (the breadth of all-time-high earnings has been inordinate), a shift toward cyclicals (there’s been some movement in this direction but this hasn’t amounted to an actual shift), weakening credit spreads (as of mid-February, investment-grade spreads had resumed their lows and high-yield spreads had recovered significantly from the pandemic highs).

A correction or a substantial pullback is highly likely in the next few months simply because of the laws of market nature. The longer we go without a pullback, the deeper it’s likely to be when it happens. If this is a big problem for you—especially as you reap the gains of this strong bull—you probably shouldn’t be in the market in the first place. Corrections are the price of admission to the theater of outsized returns.

David Sheaff Gilreath, a certified financial planner, is a 39-year veteran of the financial service industry. He established Sheaff Brock Investment Advisors LLC, a portfolio management company based in Indianapolis, with partner Ron Brock in 2001. The firm manages over $1 billion in assets nationwide.