So how does one prepare for a correction? Risk management.
Don’t put an enormous amount of capital at risk in these low probability plays.
For months, many traders have made a living selling volatility as markets hit new all-time highs. As a momentum trader, I feed off this confidence. Coupled with the low implied correlation, we are in a stock picker’s market. This strategy will fail at some point, but should we listen to the crowing about it now?
Fundamentals are very strong
From a fundamental perspective, earnings have been stellar this year and have boosted the value of companies. Jobs growth has been strong for over seven years, thanks to the good work from the previous administration and the Fed’s policies.
Earnings will remain a put option under the market until they peak (no, I don’t know when that will happen). The current earnings growth cycle is still in early stages. Productivity levels are poor, which is the main reason why our economy is not above 3% GDP. The rollbacks of prior regulatory reform has been very helpful for strong profit growth.
As always, the market will tell you everything you need to know. Right now, markets are mildly overbought. Put/call and breadth indicators are slightly oversold, while the VIX is downtrodden (too bullish). These mixed signals defer to the SPX chart, which is solidly bullish. The Dow Industrials chart is even more so. This is still a bull market, so play it accordingly.
So what’s with the market noise?
If you tune into the media, you hear dire warnings. Some analysts even joke about the bull market and make fun of those who are still in the game. “They’ll get their comeuppance, just wait and see!” They say the markets will fall, and when the markets keep chugging along, they find convenient excuses.
These warnings are often from people trying make a name for themselves. Remember John Paulson? He made a name for himself (got paid big-time) by shorting mortgages from 2007-09. His results since? Poor at best. Is that someone you wanted to invest with?
I’ve even seen articles comparing today’s current market to the one that preceded the 1987 crash. There are some similarities – complacency and skew bets – but the size and magnitude are not comparable. There are more derivative products and potential risks than in 1987, yet the Dow Industrials has not fallen 22.6% in one day since then. Even a 500-point drop would be less than a 2.7% loss. It would sting, but it wouldn’t devastate us.
Then there are those who point to the weak economy. They say the market highs cannot legitimately support such slow growth. Was the stock market so undervalued in 2009 that after yearly gains the markets finally caught up to the economy? Nope. The stock market reflects the economy six to eight months out. There are very few surprises other than the occasional shocks, which are often adjusted for right away.
The bull market is not going anywhere
Today’s stock market is built on earnings, value and some fluff (there are always some bubbles out there, we just don’t have large ones right now). While it’s good to have some historical perspective, rational thinking, common sense and solid, up-to-date information are far more valuable analytical tools.
From an investing perspective – and especially for those with a long term horizon – there are few reasons to time the market. Staying in the game and adding more to your portfolio when markets dip has been an enormous wealth creator. Stick to that disciplined approach.
Take what you hear in the media with a (big) grain of salt, and continue to listen to the message of the markets. It’ll tell you what you need to know.
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