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50 Percent Correction Is Impossible! Really?

50 Percent Correction Is Impossible! Really?

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Monday, 06 February 2017 07:55 PM Current | Bio | Archive

Measuring The Size Of The Next Correction

As a portfolio strategist, there is little question the markets are still confined to a bullish uptrend. Currently, portfolio allocation models remain near fully invested. 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.]

What causes the next correction of magnitude is unknown. It always is until after the fact. There are many factors that can, and will, contribute to the eventual correction which will “feed” on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The chart below shows the deviation from the long-term trend line. I have calculated an advance to 2400 for the S&P 500 which, as I published in “2400 or Bust”, is a reasonable target for the current “melt-up” phase of the market.

lancefebsix1.jpg

As stated above, the bull market trend which began in 2009 remains currently intact (dashed blue line). A correction from 2400 back to that bullish uptrend line, which occurred in both 2011 and 2012, would entail a decline to 2100.  That would be a 14.2% decline and while not technically a “bear” market, for many investors it will certainly “feel” like one.

But what if a simple correction accelerates? To analyze how a market accelerates to a 50% correction, we can 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%.”

lance2-(1).jpg

So, a 50% retracement from the 2400 level would push the markets back towards 1547. As identified in the chart, a 23.6% retracement from the 2009 lows would violate the bullish trend line. Such a violation would set up a change in trend, from bullish to bearish, thereby bringing more selling into the market.

If the next wave of selling starts to trigger “margin calls,” the next three levels of retracement become much more viable. The market would initially seek out support at the 38.2% retracement level of 1748 which would be a decline of 27.16% and would push the markets into an “official” bear market. As margin calls accelerate, so does the forced liquidation which then bleeds over into psychological panic selling as investors reach the point of capitulation.

This is where “buy and hold” quickly becomes “get me the $*@# out.”

That can’t happen you say? As shown in the chart below, corrections of 50% to 61.8% of the previous advance are common with corrections even eclipsing 100% as well.

lance3.jpg

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession.

But considering we are already 91-months into the current cycle and extremely levered, there is a rising level of risk that should not be ignored.

By the way, a 50% retracement would register a 35.5% decline in investor portfolios. A 61.8% retracement would destroy 43.9% of investor capital.

And that is how you get a 50% decline.  

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, they are already doing 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.

Don’t think it can happen?

You might want to reconsider.

Lance Roberts is a chief portfolio strategist and economist for Clarity Financial.

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LanceRoberts
As a portfolio strategist, there is little question the markets arestill confined to a bullish uptrend. Currently, portfolio allocationmodels remain near fully invested. Therefore, what concerns memost is NOT what could cause the markets rise, as I am already invested,but...
stock, market, correction, investors
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2017-55-06
Monday, 06 February 2017 07:55 PM
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