A couple of week’s ago I asked the question “How Big Could A Correction Be?” In that article, I compared several different technical models to establish potential correction levels which derived the following table of probabilities. Of course, as I stated at that time:
“There is no exact answer to the potential magnitude of a correction in the markets. ‘This’ depends on ‘that’ to occur which is why trying predict markets more than a couple of days into the future is nothing more than a ‘wild ass guess’ at best. However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes.”
As shown in the chart below, the recent correction fulfilled the correction to the 2013 bullish trend and got oversold (yellow highlights) on a very short term basis.
With the markets opening higher today, it appears that the short-term correction in the markets may be over as the “buy-the-dip” mentality remains firmly entrenched with market participants.
However, if we step back from the day-to-day volatility by looking at weekly data, a different picture emerges.
As shown, the market registered a signal in early January to reduce equity exposure in portfolios. Importantly, while this does not mean selling everything and running into cash, it does suggest that the markets are egregiously overbought on a short-term basis and investors should rebalance holdings in portfolios. This is done by “trimming winners,” reducing holdings back to original portfolio weights, and “selling laggards,”which reduces portfolio drag and provides future portfolio tax efficiencies.
After the initial sell signal in January, the market primarily traded sideways for the next several months, with a good bit of volatility along the way. The reduction in portfolio risk reduced overall portfolio volatility with only a minimal drag on overall performance. However, should if the markets had dropped into a deeper correction, investors would have been well positioned to “buy.” However, in May, the markets broke out of the consolidation range and the “all clear” signal was given to increase equity risk in portfolios. The consolidation process also allowed for a lower risk entry to add back additional equity exposure.
