As Alan Greenspan pointed out in his Aspen interview with Maria Bartiromo in June 2012, “An anticipated market never happens” and “Crises don’t give you notice.” The mere fact that everyone is anticipating a crash means the odds of it actually happening are reduced.
Technically stocks are overbought, and as can be seen in the monthly S&P chart below, are setting up a pattern for a fairly good correction. Corrections can come in many forms; they do not always have to be severe drops in price action. They can be in the form of a range consolidation that sometimes lasts years. Or a correction within an index can be where those products that are overvalued within the index have severe corrections but the rest do not, causing an almost unnoticeable change in the whole index.
The one good thing about corrections is that they bring valuations back in line. Markets are nothing more than a culmination of participants’ emotions. Enthusiasm creates excitement which in turn causes irrational purchases, driving valuations higher. At some point people begin to feel the asset is no longer worth the price, which leads to profit-taking.
As more people feel the need to take profits, prices come under greater downward pressure. When prices begin to fall, people think they should get out too before their profit evaporates. Eventually panic grips every market participant, with many acting to liquidate their position before it goes to zero. Of course, markets never go to zero, but just the thought that they could sends many people to liquidate their positions.
[pullquote align=”right”]The question becomes: How do we not end up being the ones that sell out at the bottom and buy at the top?[/pullquote]Widespread panic usually signals a market bottom or the end of a correction. At this point many of those that got out at the top see opportunity, as fundamentals are still the same as when they got out. So they begin buying again. As prices climb back up, those that got out with some profit will get back in, and eventually, when prices get back to where they were before the correction, those people that got out at the bottom will once again start buying. This simplistic scenario is not far from the true actions of a market. The question becomes: How do we not end up being the ones that sell out at the bottom and buy at the top?
The easy answer to that question is be the leader, not the follower. Make your own decisions with good sound technical and fundamental information and then have the financial wherewithal to stick with your decision. One irrational decision will most certainly lead to another decision with the same thought process, getting you in at the wrong time for the wrong reason and out at the wrong time for the wrong reason.
Markets do repeat themselves; that is why we all watch charts for repetitious patterns. However, the magnitude with which they repeat is almost never the same. The participants’ expectations change the general dynamics of markets, thereby changing the overall outcome.
In October of 1987, only a few people were predicting the market to sell off and very few believed them. Today, because 1987 is still fresh in investors’ minds, fear and greed will have a very different effect. Additionally, unlike 2000-2002 and 2007-2009 where the economy was falling into a recession, today the economy is picking up steam. If the Fed does start to pull back on their quantitative easing program, it will be because the economy is showing strength. This would mean company valuations would increase because of economic growth, eventually coming into line with valuations set by speculative buying of stocks.
The stock market will correct, as the chart above indicates, but I for one do not believe it will be a large correction. More than likely it will be a 12- to 18-month consolidation in a fairly narrow range, between 1500 and 1700 in the S&P.
