How to Handle a Market Correction

May 22, 2014
Marc Lichtenfeld

Recently, many Wall Street strategists and technicians have pointed to signals suggesting the market is about to sell off. While there's no way to predict when it will happen, you should prepare.

This article is published with permission from InvestmentU.com.

If you want a great stock to invest in, you should buy Crystal Ball Inc. (NYSE: BS) because it appears that in the past few weeks everyone on Wall Street is using one and they're all saying there is a big correction coming.

(For the record, if you didn't get the joke, there is no stock called Crystal Ball Inc. I don't want any angry emails saying you couldn't find the stock.)

Recently, many Wall Street strategists and technicians have pointed to all kinds of signals that suggest the market is about to sell off.

Here are some of the reasons they are pointing to for why the market should correct.

Small caps not participating

Although the Dow and the S&P 500 hit new highs last week, the Russell 2000, an index of small caps, hasn't seen a new high since early March and is currently more than 8% below that high.

Usually, small caps lead advances. The argument is the broad market rally is unsustainable without small caps.

Additionally, there is a statistic getting a lot of buzz in financial circles that the last 35 times the Russell fell 10%, the broader market declined by the same amount. The Russell 2000 hit that 10% down mark just 2 days after the S&P 500 tagged a new all-time high. Will the S&P follow and make it 36 times in a row?

On Monday in an excellent column on small caps, The Oxford Club's Matt Carr wrote, "When small caps struggle—and retreat quickly—it's often a reason for pause because it might be a sign the companies at the frontlines of the U.S. economy are firing off warning flares of a larger problem."

Skittish investors who are worried about the economy could see the small cap sell-off as proof that the economy is not getting traction, which could push all stocks lower.

The smart money is nervous

One of the most interesting arguments supporting a sell-off has to do with the so-called "smart money."

The Bloomberg Smart Money Flow Index (SMFI) tracks the Dow Jones Industrial Average minus the first 30 minutes of trading each day. The theory is most buying and selling in the first 30 minutes is conducted because of emotion. That's the "dumb money." The smart money waits until things have settled a bit and then gets to work.

So when there's a lot of selling early in a trading day, the SMFI will have an upward bias and vice versa if much of the day's buying came in the first half hour.

"Trouble usually lies ahead when the DJIA (Dow Jones) makes a high that is not confirmed by the SMFI," Ari Wald of Oppenheimer said.

You can see from the chart that while the Dow is making a new high, the SMFI is not.

If you buy into the notion that a correction is coming, there are steps you can take to protect yourself and take advantage of the situation.

Raise your stops

The Oxford Club has a standard 25% trailing stop policy that has served extremely well for more than a decade. It got us out of stocks with profits as markets were collapsing in 2008 and kept us in stocks when they made big moves.

However, in many of The Oxford Club's advisory services, which are designed for shorter-term trades, we often tighten up the stops as the positions get more profitable. So this may be a good time to raise your 25% stop to 20% or 15% on shorter-term trades.

Note, I am only suggesting this for shorter-term trades. For your long-term investments, a 25% stop still makes sense because you don't want to get shaken out of a good stock just because of market noise. We're still in a bull market and even a 10% correction doesn't mean we don't have further to run higher.

In fact, 2 weeks ago I suggested we could have another 74% left in this bull market.

Buy puts

If you're comfortable with options, you can buy puts on the stocks you own or on one of the major indexes. If the stock or index goes down, your puts increase in value, offsetting some or all of the loss in your stock.

Owning puts is like insurance. You hope you never need it, but it's nice to have when you do.

Sell covered calls

This is a conservative options strategy where you sell someone the right to buy your stock at a certain price in exchange for a premium.

For example, if Microsoft (Nasdaq: MSFT) is trading at $39.50, you might be able to sell the July $40 calls for $0.90. That means if Microsoft is above $40 at expiration (the third Friday of the month) in July, you will sell your stock at $40, plus keep the $0.90 you made for selling the call. If the stock is below $40, you keep your stock and the $0.90 option premium, offsetting at least some of the decline.

So if you're concerned about a sell-off, and sold a call, you'd have an extra $0.90 per share to hedge against the downturn.

Get your shopping list ready

Start thinking about the stocks you wish you had bought 6 months ago. If the market sells off, you'll be able to get some of them at a much better price. Whether it's a dividend stock that will have an attractive yield if the price declines or a momentum stock you'd like to own at a cheaper price, do your homework now so when the time is right you'll be ready.

I don't shop at Crystal Balls R Us so I'm not going to predict whether the correction is coming. But I am getting prepared in case it does.

Marc Lichtenfeld is the chief income strategist at Investment U. See more articles by Marc here.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.