Market outlook: Hunker down for a correction

To ride out a correction, raise your cash limit. That’s the market outlook from Keith Richards, portfolio manager of Barrie, Ont.-based Value Trend/Wealth Management. With lots of change in your pocket, you’ll be able to buy shares of reputable, but beaten down companies.

Over the last six years of the current bull market, U.S. stocks have led the pack. And for investors who managed to climb aboard, it’s been a great ride. Perhaps too great. After all, since 2013, we haven’t been hit by any volatility. And for me, that’s worrisome.

You’ll recall that as they bounced back from their bottom in 2009, markets were very volatile. And it was entirely understandable that they would be, given the round of quantitative easing unleashed by the U.S. Federal Reserve.

Investors were also spooked by Europe’s never-ending saga of sovereign debt default. But all this volatility ended four years ago.

Admittedly, we’ve had a few minor corrections since then. Yet we haven’t been hit with a big shift — say, of 20 per cent — since 2011.

And if any stock market is to stay healthy, it periodically needs corrections of 20 per cent or more. In other words, our stock market outlook is that we’re overdue for a wakeup call.

Moreover, U.S. presidential election cycles suggest such a correction might occur later this year. During the first half of the year before a presidential contest, markets are typically strong; but during the second half, they’re typically weaker.

Moreover, seasonal cycles for weaker markets usually come into play between May and October.

Market outlook indicators call for correction

Then, too, a correction this summer now looks more than likely. Consider the VIX, the market volatility index of the Chicago Board Options Exchange. Not only does the index show the lack of volatility since 2013, but it shows that the index itself has been hovering around the bottom of its long-term range, which indicates investor complacency.

There’s also been a change in market breadth on at least one of the indicators I follow.

For example, the high/low chart shows a divergence between the S&P 500 and the net ratio of new highs versus new lows on the New York Stock Exchange. It was just such a divergence that signaled the market meltdown of 2008-’09.

True, in 2013, divergence on the chart turned out to be a false flag. Yet that may have been because the angle of descent of the new high/low indicator wasn’t as steep as it was in 2007. But the angle of descent is now quite steep — as steep as it was eight years ago.

Other signs we may be headed for a sharp correction are the bearish readings on various indicators of market sentiment.

Smart money’s market outlook is bearish

I’ve written about these readings before. But by way of a quick explanation, sentiment indicators gauge the bullishness or bearishness of the market outlook of certain groups of investors.

Folks who are generally correct in their investment outlook are known as smart money. They include company insiders, commercial hedgers, as well as managers of big pension funds.

Not surprisingly, folks who aren’t as accurate in their investment outlook are known as dumb money. This group typically includes retail investors, small speculators, and buyers of mutual funds, along with traders of odd lots.

As you might expect, it’s crucial to follow the market outlook of smart money — especially when it’s moving in a direction opposite to that of the dumb money. And the smart money crowd is now almost twice as bearish as its polar opposite.

Admittedly, these sentiment indicators are poor in predicting where the market will go over the short term. But they’re usually very accurate in predicting market movements a few months hence.

Of course, the indicators I follow aren’t foolproof. The low-volatility bull could very well continue to snort and puff his way right into the summer.

But from my investment outlook, I’m betting on the opposite. That’s why 30 per cent of our holdings are now in cash. And we’re planning to raise that to 35 per cent over the coming weeks.

In fact, as protection against a mid-year correction, we’ve been working to limit portfolio risk. And in the weeks to come, we may take additional steps to safeguard our clients’ holdings.

Sell high beta stocks to raise your cash

For starters, we could cash out even more of our investments. As I’ve already hinted, raising the cash component of our holdings is our most important tool for risk management.

Another tack we might take is to sell those holdings that have high betas — in effect, risky stocks. Such stocks are often found in the high-tech sector.

We might also use exchange traded funds to buy into sectors with low risk, such as consumer staples and utilities in the U.S.

For the former, a good ETF is the Consumer Staples Select Sector SPDR (NYSE─XLP); for the latter, the Utilities Select SPDR (NYSE─XLU).

Canadian real estate investment trusts are another sector that’s now low-risk. Therein, we like Allied Properties REIT (TSX─AP.UN), Cominar REIT (TSX─CUF.UN) and Chartwell Retirement Residences (TSX─CSH.UN).

Yet another path we might follow is to buy hedge-type ETFs, such as Advisor Shares Ranger Equity Bear (NYSE─HDGE), that benefit from a fall in the stock market. This fund, which shorts a basket of U.S. stocks with higher valuations, has an almost-perfect negative correlation to the S&P 500.

And last, but not least, we could always buy commodities such as oil or gold, but only if they appear to be moving counter to the direction of the stock market. Admittedly, when it comes to these commodities, my market outlook is still on “watch” mode. But, of course, I could always change.

To take advantage of any correction, make sure you have cash on hand. That’s because a correction like the one that seems to be heading our way will be a screaming opportunity to buy.

It never fails to amaze me how the high priests of buy and hold always, in their investment outlook, say that a market correction is a buying opportunity.

After all, if an individual is fully invested, as the buy-and-hold crowd says he should be, what cash will he have to buy beaten down, but still reputable stocks?

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846