When Will the Correction Come?

12/01/2009 1:00 pm EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, president of Stack Financial Management and InvesTech Research, says a correction will come sooner or later—but probably later.

Is a correction imminent?

In a word, Yes.” But corrections are always imminent in bull markets, with the only question being how severe the next correction will be.

On average, a 5% correction comes around every 5.8 months in a bull market. So, the fact that we’ve already had three such corrections in eight months proves that this bull market is anything but “correctionless,” as some will claim. (We believe that corrections are healthy in a bull market.]

Larger corrections, of 10% or greater magnitude, are far more rare. However, every bull market since 1929 has experienced at least one 10% correction before hitting the final bull market high and entering a bear market.

On average, a 10% correction occurs only once every 29 months. So, the fact that we’ve gone eight months without a 10% correction could hardly be called abnormal or dangerous.

So, how long until that first 10% correction?

  • On average, bull markets traverse 308 market days before entering their first 10% correction. So, the current bull market [likely] has almost three more months to run before entering that higher probability region of a 10%+ correction.
  • In size, the current 64% gain already surpasses the average 55% gain seen prior to the start of a 10% correction. That might worry us more if not for the fact that this bull market has followed the largest bear market loss since 1932, and that major indexes need to gain another 40% to achieve their old highs.

In addition, there is a seasonal occurrence that usually provides higher prices—or at least stability—through January.

The Santa Claus rally is a widely recognized truism on Wall Street, and it’s actually supported by statistics. Over the last four decades, the average gain from November 20th through the end of January has been +4.2%, which would be an extraordinary +23%, annualized.

If November’s early strength continues this year, it may be an indication that investors are feeling more secure about the market and the economy in general.

So, how do you prepare for the possibility of a 10% correction?

In a word, you “don’t.” Instead, you should stay focused on the longer-term underlying technical models to watch for the traditional warning flags that a bull market may be nearing its end. It’s the bear markets that matter, not the corrections.

And frankly, we don’t know how to anticipate short-term corrections. However, we can tell you there is significant profit risk if one tries to step out, or gets “stopped” out, during that first 10% correction. [In most] bull markets over the past 80 years, over 70% profit gain remains after that first 10% correction.

So we won’t get worried about the short-term outlook or the possibility of a correction unless technical indicators begin a significant deterioration.

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