Where's the Market Correction? Four Ways It May Still Happen
Despite its nasty reputation, this September has not triggered the long-awaited stock market selloff.
Though the gains certainly wouldn't be characterized as robust, the market has more than held its own so far this month. Instead of a correction—generally defined as a 10 percent pullback—the six-month rally has largely continued.
So what happened?
Continued declines in the dollar have boosted commodity trading, particularly in gold and oil, which in turn has pushed correlated stocks higher.
Meanwhile, money managers who stayed cautious once equities started rallying are using any dips in the market as opportunities to make up for lost time.
Finally, the news cycle has remained fairly positive, with a smattering of high-profile companies such as Federal Express preannouncing that their earnings would beat expectations.
Is it time, then, to sound the all-clear?
"This is the most difficult environment we've ever been in. Individual clients are anxious," says Kathy Boyle, president of Chapin Hill Advisors in New York. "We see signs of speculation from some of our clients that are not connected to reality."
Indeed, the market faces any number of pitfalls ahead that could step in front of the rally. Four to consider:
1. Unexpected News From the Financial World
Yes, the news has been mostly good, or at worst better than nightmarish scenarios many had envisioned for the market.
But what if the so-called second derivative—a term analysts use to describe bad news getting better—doesn't change and there aren't true positive signs for investors to grab onto?
"News can trip it up," says John Buckingham, CIO at Al Frank Asset Management in Laguna Beach, Calif. "If the economic statistics don't continue to show modest improvement, then that could be a big hiccup for investors."
Unemployment, after all, remains high, and Friday's improving consumer confidence numbers were shrugged off by investors. Should negative sentiment take hold, it could drive the market down just as quickly as it went up.
"What happens if you get the runaway train?" adds Buckingham, who remains mostly bullish on the market but believes investors should be mindful to take profits periodically. "Our strategy is to plant when it's the time to plant and harvest when it's time to harvest. These days we've been doing more harvesting."
2. Unexpected News Outside the Financial World
Geopolitical hazards remain a strong headwind for the market, and should the situations in Iran or Afghanistan explode, or if there is a significant event elsewhere in the world, that could damage the market.
"Any big, major event overseas that shakes us up, that could be something" to unnerve the markets, says Boyle, a market bear who senses a level of nervousness from technicians that a significant occurrence is on the horizon.
Such an event could roil trade in the dollar, the sharp decline of which Boyle attributes to the market improvement.
The market also has relied on the strong demand in Treasury auctions, something else that could be disturbed by a global event. Foreign buyers have been relied on heavily to cover US debt offerings.
3. Technical Pressures
The light trading volume that has dominated the market is one indicator that the average investor hasn't returned yet and the current levels are being driven by traders in the pits as well as computerized and high-frequency buys.
That has raised worries that the market lacks fundamental underpinnings and could tumble again if certain technical levels don't hold up.
"You are already in the plus-50 percent return category from the March low without a pullback," says Rick Bensignor, chief market strategist at Execution LLC in New York. "The more you rally, the more you pull away from any significant support levels, the more risk you take on an outright long position."
To protect against too much exposure to the long side, Bensignor has been advising clients to use pair trades, which combine long and short positions.
For example, he's current long the SPDR Select Energy ETF and short the SPDR Select Financial because he believes energy will outperform financials. He has a similar trade in which he's pairing a long position in industrials against a short in consumer staples.
"By playing pair trades you take the market risk out of the picture and you have relative performance," Bensignor says. "If you do your analysis correctly you should make money regardless."
4. Value Traps
Advisors caution against so-called "value traps," in which investors perceive a sector or stock to be a bargain simply because its price is beaten down. That's not always the case, and the trap can become especially enticing in a market that is still 30 percent off its historic highs.
"Roughly three out of four times, industries that are identified as value traps have failed to outperform the market in the subsequent month," Bank of America-Merrill Lynch said in a research note.
The firm noted five sectors likely to be value traps: Beverages; energy equipment and services; food and staples retailing; food products; and hotels, restaurants and leisure.
Buckingham's firm specializes in value-based investing but says it can be a subtle distinction between determining value or a trap.
"You do need to be very cognizant of the underlying business and its potential for growth over the next few years," he says. "The expectations are your home runs will make up for your strikeouts, and you won't strike out as often as hit home runs."
As an example, he recently bought stock in MGM Mirage , which some considered a difficult pick because of some balance sheet issues. Yet the stock has gained 45 percent in September.
"Was it a value trap or a value play? Hindsight's 20-20 but as of right now it was a great value investment," he says. "The distinction between traps and opportunities is a fine line."