In Uncategorized on January 29, 2010 at 17:59

The long-awaited stock market correction may be at hand.

One of the fundamental conundrums of investing is that we may be absolutely correct about something and yet unable to profit. Making money on an insight requires two conditions: The information cannot already be priced into the market, and other investors who do not already share that information must come around to our point of view.

There are times when the conventional wisdom about something may well be correct. If the conventional wisdom is already reflected in market prices, then profit opportunities are slim to nonexistent. I’ve been saying for some time that stocks appear overdue for a correction, simply because they’ve advanced so far without one since last March. Stocks do not go up in a straight line. There will be a correction. The only question is when.

So let’s check for our two conditions. First, is this cautious outlook already priced into the market? In recent weeks I’ve wondered, with so many commentators and money managers talking about how stocks have gotten ahead of themselves. Still, someone was buying. I’ve learned investors may say one thing, but do another, especially when the market doesn’t immediately confirm their stated conviction. My hunch was that people were expressing caution, but not actually selling — and in many cases continuing to buy.

As for the second condition, my belief that there would be a correction has seemingly lacked the concrete evidence to shift investors’ views. Economists believe the recession ended sometime last summer. Holiday sales were better than expected. Consumer confidence is up. Corporate profits have been surging. The outlook has been looking rosy, at least for anyone who has a job.

Then, suddenly, the outlook shifted abruptly. A Republican victory last week in Massachusetts exposed a seething electorate and threw Washington into disarray. President Obama responded to the furor over Wall Street bonuses with much tougher banking proposals, including a tax and a ban on proprietary trading. Fairly or not, populist fury zeroed in on the Federal Reserve and its chairman, Ben Bernanke, whose confirmation suddenly seemed in doubt.

Until then, few had seemed to take seriously the possibility of partisan meddling with the independence of the Fed. But last week it seemed all too real. Meanwhile, unemployment continued at high levels, and the likelihood of a robust recovery seemed much diminished.

In short, all the elements of a correction had materialized.

I suspect I was as surprised at these developments as most people. I didn’t know what would cause a correction — only that something would. Anyone following the Common Sense system should be prepared, having raised cash and, perhaps, invested in some short ETFs.

Despite some complaints that short ETFs don’t always perform as advertised, these have done their part during the recent sell-off. I used them to hedge my positions in two stock index funds, and they’ve done exactly that. When the market reaches the next Common Sense buying threshold — that’s 10% below the Nasdaq’s  recent high point, or roughly 2090 — these will be the first positions I’ll sell.

Last week’s three-day decline in the major averages — just over 5% — doesn’t yet constitute a correction (a 10% drop is the standard definition). There’s no certainty we’ll get there any time soon. But last week’s sudden drop is a reminder that we will eventually — probably when we least expect it.

Report card: Last week the put options I sold on various bank stocks expired. All were out-of-the money — trading at higher than the strike prices — so I kept the proceeds and have no further obligation to buy the shares. With bank shares dropping and option spreads rising during the recent selloff, a similar opportunity to sell put options in bank stocks may be taking shape.


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