How To Prepare For The Coming Market Correction

| April 20, 2010 | 0 Comments

The market’s 13 month rally had me wondering if the laws of physics no longer apply.  The market has been defying gravity for so long now it almost seems natural.

I’m sure Isaac Newton would agree.

As of last Thursday’s close, the S&P 500 Index was up an amazing 82% from the March 2009 low.  And, the index topped 1,200 last week for the first time since the early days of the financial crisis in late 2008.

It’s been a truly historic rally.

What’s been even more amazing is the market’s resiliency.  Since bottoming in March 2009, the market has pulled back between 5% and 8% on five separate occasions.  But, we haven’t seen a full correction of 10% or more.

However, that may be about to change.

Signs are emerging a long overdue correction is finally at hand.

On Friday, the S&P 500 suffered its first daily decline in seven trading sessions… dropping 1.6%.  It also closed lower on the week for the first time in seven weeks.

What prompted the selloff?

The SEC shocked investors by leveling both barrels at Goldman Sachs (GS).  Wall Street’s cops alleged Goldman misrepresented a mortgage-backed security it sold to investors.  And, the usually bullet-proof Goldman found itself on the business end of an SEC civil fraud lawsuit.

News of the SEC lawsuit sent a shiver through Wall Street.

Fearful investors not only began piling out of Goldman, they also started scrambling out of other major bank stocks.  Shares of Bank of America (BAC), JPMorgan Chase (JPM), and Morgan Stanley (MS) all fell sharply on Friday.

Investors are afraid the Goldman suit is just the tip of the iceberg.

They’re worried the SEC is preparing similar lawsuits against other major Wall Street firms.  And, they’re concerned such lawsuits could undermine the financial sector’s fragile recovery.

If investors begin exiting financial stocks en masse, the selling could easily carry over to the broader market.  A new scandal in the financial sector is just the kind of event that could spark a full-blown market correction.

And there are plenty of signs the market is ripe for a correction.

Take consumer confidence for example.

Economists were expecting consumer confidence levels to increase in April.  But, they fell unexpectedly.  If investors begin worrying consumer spending levels might lag, we could see them let some air out of the market.

Another sign we’re near a market top was recently provided by company insiders.

Last week the Thomson Financial Insider Transactions ratio showed insider selling is outpacing buying by a whopping 40:1.  When insiders are selling at this rate, it’s usually a strong sign the market’s headed for a fall.

And, if these signals aren’t enough, consider the extremely bullish views of professional financial advisers.

The most recent Consensus Bullish Sentiment Index reading was 76%.  Any reading over 75% for this contrarian indicator means the market is overbought.  The theory is if most financial advisers are bullish, the market is probably due for a fall.

As you can see, we have some strong signs the market is poised for a correction.  But, don’t fret.  The occasional correction is actually a good thing for an upward trending market.

What should you do to prepare for a correction?

Take a hard look at your stock holdings now.  Consider taking profits in your biggest winners.  Especially if they are higher risk stocks like small-caps, biotechs, technology, and the like.  These are often hit the hardest in a correction.

Of course, if your positions still have good long-term growth potential and you got in at a good price, you may want to hang on to some of your shares.  I don’t see the market heading back down to the March 2009 lows.

Also, consider exiting any positions that have small gains or outright losses.  If they haven’t performed well in this market, they probably won’t hold up in a correction.  You have to ask yourself if you’re prepared to suffer even bigger losses.

Perhaps this is a good opportunity to exit these underperformers with just a small gain or loss?

The point is, now is a good time to raise some cash.  A correction will provide a good second chance to get into top performing stocks at bargain prices.

The last thing you need to do now is get your shopping list ready. Identify the stocks you want to own but missed on the way up.  Be prepared to put your cash back to work as soon as the good buying opportunities appear.

Follow these suggestions and make any market correction work for you. Don’t let what should be a very good buying opportunity pass you by.

Tags: , , , ,

Category: Stocks

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

Leave a Reply

Your email address will not be published.