The recent pullback in the S&P500 was a mere 4%, but it generated a lot of news and speculation. The 4% pullback worked some of the overbought conditions off, but it did not reach the short term trend in the index that began in the spring of 2013 (green line). But short term trends are like bugs flying down the highway, sooner than later they will get smashed and forgotten. The long term trends do matter to us and as the S&P500 pulls further above the trend, risk of a larger correction increases. But the question is always when?
We have been calling for a summer/fall correction and not because it has been three years since we have had a significant correction–the last large correction was 17% in the summer of 2011. We have been calling for a correction because we are in the seasonally weak period for equities and we are in the summer of discontent–the summer of the largest average correction of the four year presidential cycle.
History tells us most of the corrections and drawdowns in the indexes happen in the summer/fall time frame. It’s not that we don’t have corrections in the winter, we do, but on average the indexes in the fall of the year are about where they were 6 months prior (see red arrows). So if you like roller coasters just remain a buy and hold investor. Otherwise, it helps to know how to step aside when risk increases and future returns are at their lowest.
Another 17% correction would take the S&P500 down to 1630 which also happens to be our summer time trend line–note the market completely missed this last summer. Looking back to 2011, the market pulled back 7% then rallied but failed to establish a new peak. If the short term (blue) trend line fails this summer expect to see a more significant correction occur. The current correction may still bounce off the short term trend line and rally. But if the follow-on rally fails to establish a new high, a larger fall correction may be in the works.
Our models already have us out of the market for the summer/fall and we hope to get in at better valuations in the fall. We recognize this does not always happen, but it happens enough for our strategy to significantly beat the indexes over a full market cycle.
So to answer the question, it would be surprising from a long term trend perspective for the correction to be over. But there is always a caveat and it is that so far the short term trend has held and the market can stay over valued for surprising long periods of time. With that said reduced exposure in times of increased risk pays off in the long run. We still expect another correction before our models tell us when to re-enter equities in the fall.