...and a Look at Corrections

03/03/2006 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

"It’s been a long time since this market had a correction of any reasonable size," says technical expert and options specialist Larry McMillan . Here, he looks at the history of corrections, his current forecast, and several short-term stock and options plays.

"Ever since the broad market, as measured by the S&P 500 ($SPX) bottomed at the end of the last bear market in March, 2003, the rise has been inexorable. Corrections have been virtually non-existent, and while the pace of the rise might be too slow for some bulls, there is little argument that it has been steady. Similar comments were being made after the 1990 bottom (the other Mideast war bottom). S o we ran some programs on our historical data base to see if some conclusions can be drawn. Sure enough, it turns out that the current lack of corrections is historic in nature.

"In the past, similar lengthy times between corrections have not necessarily signaled the end of a bull market, they did always lead to a sharp, sudden, and unexpected decline. Perhaps ‘unexpected’ is the operative word, for when the market goes so long without a correction of any sort, most traders and investors get lulled into the feeling that there isn’t anything that can knock the market down.

"Right now, there seems to be a budding feeling of that sort, at least in the mainstream financial media: no matter what interest rates do, no matter what oil does, no matter what political problems arise, and no matter what earnings do, the market continues to rise. Eventually, this type of bullish expectation disintegrates into a torrent of selling, as suddenly-bearish traders all try to get out the exit door at the same time. Here, we look at past occurrences of lengthy market periods without correctiona nd see how they ended.

"From the market’s bottom in 1990, after Iraq had invaded Kuwait, until the summer of 1996, there had not been a 10% correction. That encompassed a period of 2,158 calendar days. It is the all-time record between 10% corrections. However, in that period, there was a correction of about 9.7%, and thus that was a virtual correction of the required magnitude. So, perhaps it would be better to view our market in light of the longest periods without a 9% correction.

"In that light, the longest period without a 9% correction was the period between the 1990 bottom and that aforementioned 9.7% correction in the first quarter of 1994a period of 1,280 days. The second longest period of time in history without a 9% correction is occurring right now 1,104 days and counting. Thus, in this light, we are now toying with the all-time record not something to be taken lightly. The following table shows the nine lengthiest periods of time without a 9% correction and also shows the size and speed of the eventual correction.

Days without
9% Correction
Size of
Correction
Days in
Correction
Dates of
Correction
1280
9.7%
60
Feb-Mar ‘94
1104
Current
1029
9.4%
108
Jan-Apr ‘53
1980
10.9%
46
May-Jun ‘65
838
11.0%
54
May-Jul ‘96
779
10.2%
18
Aug-Sep ‘86
756
10.7%
18
Sep-Oct ‘55
711
9.2%
49
Aug-Sep ‘59
686
9.2%
6
Oct ‘89

"Note that the corrections are swift when they come. The eight entries in the above table averaged only 45 days each. In other words, it doesn’t take long for the drop to occur once it starts to build up a head of steam. Furthermore, since the current hiatus is in second place all-time, we would expect something similar when the correction finally comes.From a more positive perspective: none of these corrections ended the bull market that was ongoing at the time; they were merely a correction within it.

"So the thesis that a correction is healthy for the market is probably a correct one. No matter how you look at it, the current bull market has not corrected since its inception in March, 2003. It is thus one of the longest times in history without such a correction. Odds are that a 9% correction or larger is due fairly soon. Meanwhile,  we are nearing the top of this year’s trading range, and it appears that $SPX might be able to break out on the upside. We would expect any upside breakout to engender some follow-on buying from both short covering and from momentum traders (aided by the boost the media will provide).

"From a trading viewpoint, one way to play this is to wait, and if the upside breakout occurs, take a trading position, and plan to exit within a short period of time (say a 20- point rise in $SPX) Our recommendation for options trader is a conditional call buy for the Standard & Poor’s 500 Index (SPY ASE). Our advice is to buy if the Index trades above 1295 and double your position size if its closes above 1295. We are using the SPY March 129 calls for this position. If $SPX rallies, plan to sell half your position if its trades at 1315. Stop yourself out on a close below 1275.

"It is also interesting to note that there are buy signals in gold stocks, natural gas index and stocks, and oil service index and stocks. While these are not necessarily favorable charts, the buy signals do have a good track record. So we are first going to take a position in Chesapeake Energy (CHK NYSE). We are buying the CHK April 30 calls at $2 or less. If bought, stop yourself out on any close below 28. We are also buying calls on Bristol-Myers (BMY NYSE). Our position is in BMY April 22.5 calls at a price of $1.30 or less. If the BMY calls are bought, use 22.30 as a stop."

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