Category: Market Corrections

I don’t know if the current correction is over. What most of us know is that stock indexes hit their momentum lows on January 20th and they have been in an extremely choppy, back-and-forth environment ever since. This is a normal price action after big and fast drops. If past history is a good guidance, we are very likely to see a re-test of the momentum lows at some point. If the test comes with some form of breadth divergence – for example, a smaller number of stocks making new 50-day lows compared to Jan 20 or smaller number of stocks dropping below their 50dma, and we see heavy institutional buying, then we might have a major sign of a bottom. Remember, bottoms are formed by heavy buying, not heavy selling (even though the latter often happens first).

The more interesting question here is, what are the best-performing stocks after a deep market correction?

1. The ones that sold off the most during the correction. Many of them are priced for bankruptcy. The moment the market realizes that it is not likely to happen, we could see some extreme moves in those stocks. And by extreme, I mean 100% to 300% moves in 2-8 weeks. In the current environment, these are oil & gas, steel stocks, emerging markets.

2. Growth stocks that held the best during the correction. Growth stocks are usually high-beta names that get hit pretty hard in times of market panic. If any of them manage to hold above their 50-day moving average, build a new base or even attempt to make a new 52-week high during the correction, they will likely outperform significantly during any bounce attempt. Note that I accentuate Growth. During corrections is normal to see low-beta, high-yield groups like utilities and consumer staples to hold better than the rest of the market, but they are not going to outperform during a market recovery.

Keep in mind that there are different types of corrections. In a garden-variety 5-10% pullback above a rising 200-day moving average, momentum stocks with the highest relative strength during the correction are likely to significantly outperform during a recovery. After a deep >20% correction below a flat or declining 200dma and especially after a long bear market, many of the best performers will come from the most beaten down stocks that were priced for bankruptcy, but managed to survive.

Some corrections turn into bear markets. They are rare, but they happen. Bull markets reward risk-taking, but when the bear puts out honey, he is usually laying a trap. In bear markets, you buy when the fear of losing is very high and you sell when the fear of missing out is very high. As usual, easier said than done.

A couple weeks ago I shared some of my musings about market corrections. Here are a few more of them:

 

1.Bull markets reward risk-taking, but when the bear puts out honey, he is usually laying a trap.

2. In bear markets, indexes can remain oversold longer than most dip buyers could remain solvent. In bull markets, oversold market breadth readings lead to bounces. In bear markets, short setups often continue to work even during oversold conditions, especially during the initial stage lower.

3. Never say never. Absolutely anything can happen. Even stocks of the strongest companies can and will decline substantially during market corrections. When a market correction starts, some of your stocks will gap below your stops. Justifying holding individual positions below their stop levels, because the general market is oversold or might soon become oversold is not wise. Losses could escalate very quickly in a bear market. Act as a professional and take your next best loss. Not selling your losers means that you believe that they will outperform the rest of the available setups. Whether you are a trader or an investor, if you deal with individual stocks, you always need to have an exit strategy. If you can’t take a small loss, sooner or later you will have to take a very large loss.  Consider potential future winners you might miss because of the effect of a larger loss on mental attitude & trading size.

4. You could be right on a market and still end up losing if you use excessive leverage. Bear markets are very volatile. A small move against your overleveraged position could take you out. This is why averaging down in the midst of a correction is not for most people. It takes a strong stomach and a very deep pocket.

5. In bull markets, oversold technical readings lead to a bounce. In bear markets, you need a major news change like FED or ECB announcement for a rally. Some of the most powerful rallies happen below declining 200-day moving averages.

6. When you are in a losing streak, you can’t turn the situation around by trying harder. Go to cash in order to gain some objectivity. Take a break from the markets.

7. Buying stocks of companies, which products & services you love and use works great in a bull market. Not so much in a bear market.

8. Price action might impact fundamentals just as much as changes in fundamentals can impact price action. Sustained lower stock prices eventually lead to worse fundamentals in many cases. Low P/Es today often foreshadow lower earnings in the future.

9. Recency bias and placebo effect rule much of market’s action. Price action often defines the tone of news. Scary headlines tend to appear after markets break down. Positive headlines appear after markets bounce. With other words, the market is better at predicting the news than the news is at predicting the market.

10. Appreciate all trending markets – up or down. A downtrend is better than a choppy market. In fact, stocks tend to move a lot faster during corrections. Corrections are rare and a good trader knows how to take advantage of them. In fact, a good trader appreciates and loves corrections, because they provide incredible opportunities – first on the short and then on the long side. A correction is among the best things that could happen to a prepared trader with a plan of action.

11. When most people feel like buying the dip is a good idea, it is usually not. When most panic and start wanting out at any price, it is time to enter for trade. It is easier said than done. It is not something that can be quantified or explained. It is something that has to be experienced, multiple times. One hint regarding bottoms: they are made by heavy buying, not heavy selling (even though the latter is often a prerequisite).

12. 80% of bear markets or steep corrections is choppy price action, which might whipsaw both bulls and bears. Long bear markets make smart traders appreciate bull market a lot more, not take them for granted and take a lot better advantage when they come back. They always do.

13. Bear markets turn investors into day traders and traders into buy & hold investors. By the time a bear market is over, most active market participants are conditioned to take small gains. This might turn into a drawback in the initial stages of a recovery, when markets become less choppy and trend better.

Don’t worry about what the markets are going to do, worry about what you are going to do in response to the markets. In the end, we should focus on only what we can control: our market exposure, equity selection, entry, exit and position size.

Check out my book, CRASH – How to Protect and Grow Capital during Market Corrections.