Wednesday, June 20th, 2018

How Badly Will the Market Correct?

 

The over-bought US stock market is due for a correction. How likely is that and how badly will the market correct? Kiplinger in their article about how to survive a 10% correction notes that since 1932 the market has experienced a 10% to 20% correction on the average every two years. The last such correction was in 2011! Here is their advice.

While stocks continue to hit record highs, take some profits from your winners and build a cash reserve. You may also want to unload some clunkers. When the market finally sinks, scoop up bargains.

And Kiplinger is not the only one concerned about a correction coming sooner rather than later. CNBC quotes Byron Wien who says the Dow could suffer a 2,400 point blow at any time.

Wien, vice chairman of Blackstone’s Private Wealth Solutions group, gives a 50 percent probability for a deep sell-off by year-end. He’s been in the correction camp all year – and says he’s concerned it hasn’t happened yet.

“The market is overbought and investors are optimistic,” said Wien. “An overbought market with optimistic investors is vulnerable, and the question is what triggers the vulnerability?”

Possible triggers include a meltdown in the Middle East after Trump’s recognition of Jerusalem as the capital of Israel, worsening tensions or conflict with North Korea, the special prosecutor investigation into Trump and his campaign coming closer to home or simply a trading glitch that sets off a selling panic.

How Bad Could It Get?

Three things affect how badly a vulnerable market will fall in a correction. One is how overbought it was in the first place. The second is the amount of leverage that hedge funds have in an overpriced market. And the third is when mom and pop investors, who are entering the market now, start to lose and pull out everything in order to preserve a few dollars of their retirement savings. All three of these factors are in place which could turn a 10% correction into something worse. As an example, the 1929 stock market crash resulted in a 89% drop in stock prices before the market bottomed out in 1932. The stock market did not regain its pre-crash value for 25 years!

Just a Random Event Could Tank the Market

The New York Post noted the fragile state of the stock market where it briefly fell and then recovered based on news about the ongoing Trump-Russia meddling saga.

The stock market tanked briefly last Friday on a misleading ABC News report that made it seem as though President Trump’s legal problems were increasing.

That report, which got an ABC News correspondent in deep trouble, said Trump gave orders to retired Lt. Gen. Michael Flynn (then a national security adviser) to contact the Russians before he won the election.

It was later corrected that the order came after Trump had won – during the transition.

On that correction, the stock market regained most of the ground it had lost.

Friday’s action gave us a preview of what is going to happen if Trump gets into real trouble.

How badly will the vulnerable market correct. Time will tell but options traders will be wise to hedge their bets with strategies like a long straddle.

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