Markets may experience a 20% correction this year

January ended with a loss of 64 points on the S&P 500 in 2014 –and last month was no different with a loss of 66 points. Theoretically, January is supposed to indicate how the rest of the year will go. The Stock Trader’s Almanac notes that as a barometer, January has been a pretty good one. Since 1950 it missed eight times – of which three of those times have been in the past six years. Last year the S&P closed higher by 11%. Our TSX didn’t follow the S&P 500 last year. The TSX closed January in 2014 +0.54% and has done the same this year (+0.25%).

I’ve noted that making predictions surrounding market movements becomes increasingly difficult the further out you project. This is because of the potential of longer termed anomalies presenting themselves that can and will disrupt your current analysis. However, I will stick my neck out a bit here, and present some thoughts that I put together for our clients here at ValueTrend.

One of the ways that we have managed to provide our clients with above average returns with below average risk has been through selling when markets look overvalued. We believe that the stock markets are overdue for a correction – one that will likely occur in the second half of this year. Several pieces of evidence add to this opinion:

• The Shiller inflation-adjusted PE ratio is over 26 X trailing earnings; a level that has proceeded corrections in the past. See chart above, courtesy www.multpl.com.
• The US dollar (USD) has become overbought in the face of its sole leadership in economic growth. The train has to stop at some point. The US Fed has threatened to raise rates, but such action may not be as aggressive as some think. This may weaken the greenback, given the anticipation of a more aggressive rate policy than may be the reality.
• Corrections of 20% + are normal for a healthy stock market. The US markets have not had such a move since the summer of 2011. The five year bull/bear cycle, and common sense, suggest we are due a correction. See chart below.

• Presidential electoral cycles suggest strength in the first half of a pre-election year (2015 is such a year), followed by a weaker second half.
• Volatility has increased from the 4^th quarter of 2014 into the current year – see the VIX chart below. This can be a sign of a market transition from up trending to corrective action.

• Perhaps most importantly: Sentiment indicators are SCREAMING overbought. Dumb money (retail, mutual fund investors) loves this market. Current levels of optimism have historically lead into corrections.
• Finally – although not related to the USA, our economy is and will continue to falter in the face of weak oil prices (which will recover, but not to their old highs any time soon). Thus, the Canadian dollar will likely remain weak, and our bond yields will stay low.

How we will limit our risk

Bullish seasonality and presidential cycles prevail, along with the overall trend on the markets, which remain bullish. However, we are preparing to limit risk in the event of a mid-year correction. Such hedging activity – going forward – may include:

• Raising cash
• Reducing USD exposure by focusing on selling some, although not all, of our US stocks
• Increasing commodity exposure that will benefit from a weak USD such as oil and gold
• Hedge type ETF’s that benefit from a declining stock market (e.g. HDGE-US)

ValueTrend Performs

Our equity platform has reduced market volatility and outperformed most indices. Note how smooth our performance line is (thick black line) vs. the more jagged, volatile stock markets. Technical analysis shines the most during bear markets, and our equity platform offers proof to that claim.

Below is the performance for the ValueTrend Managed Account Equity Portfolio.  The portfolio does not contain bonds or fixed income allocations.  The figures are based on the portfolio holdings of Portfolio Manager Keith Richard’s account in the equity portfolio since June 30, 2009 and is gross of any fees and assumes re-investment of all distributions with no cash outflows or inflows.

Disclaimer:
The information contained in this report is for illustration purposes only and was obtained from sources that we believe to be reliable however, we cannot represent that is accurate or complete. The portfolio may invest in leveraged or inverse exchange traded funds and thus there may be exposure to aggressive techniques which may magnify gains and losses and can result in greater volatility and be subject to aggressive investment risk and price volatility risk. All performance data represents past performance and is not necessarily indicative of future performance.  WorldSource Securities liability shall only be attached to the accuracy of information contained in your official statement of account and information in your official statement of account will always take precedence over the information contained in this illustration. Worldsource Securities Inc. is a member of the Canadian Investor Protection Fund and sponsoring investment dealer of Keith Richards.