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Monday, March 19, 2012

Stocks ripe for a significant correction in the short-run

We are currently at 1,406 on the S&P 500; a level which gives me great pause.  I have been and continue to be one of the most optimistic commentators on the markets, with a 1,500 target for the S&P500 sometime this year.  However, I did not expect to see the index skyrocket straight up to 1,500 with no pull-backs.  We ended 2011 at 1,257.  So far, we have seen the index rally almost 12% year-to-date.  Apple has been a key driver for the markets, rallying from $405 a share at the end of 2011 to about $600 per share, or by 48% year-to-date.  As I have written, the chart is parabolic - going vertical.  This pace cannot be sustained, and the higher Apple and the market go, the more risk to the downside we face.

The small investor is largely responsible for driving the current overbought condition the markets are experiencing.  Cash has now begun to come out of the long end of the bond curve and into stocks. This means that bond investors are assuming more risk than they are comfortable with, to try and capture some additional return, since bond yields are so low, and bond prices are so high, leaving little room for attractive or acceptable bond market returns.  Bond investors are extremely fickle when it comes to risk, and will exit very quickly from stocks, at the first sign of trouble.

Just as we have witnessed accelerating buying on the upside, and markets driven to extreme overbought conditions, we will see momentum build on the downside as the markets roll-over.  Virtually everyone who has invested in stocks over the past six months has a significant profit (on paper). They will not want to see those profits erode, once stocks start to sell-off.  The rush to lock-in paper gains will drive an avalanche of selling pressure, which will drive the stock market down well past normal correction levels, to an extreme oversold level.

Stock investors must accept and become accustomed to the wider swings and heavier volatility of today's equity markets, which are driven by small investors, more fluid capital flows from all asset classes, including bonds, gold, and even real estate, and the linkage of international markets and currencies, making it much easier for foreign investors to get in and out of U.S. markets.  With this greater volatility comes greater risk, but also greater opportunity.  However, it also demands that investors alter their was of thinking and investing to both protect profits from significant corrections, and raise cash to increase flexibility, to have the ability to invest when markets correct to oversold levels.  While there may be certain times when a buy and hold strategy can work for a given market environment, these times will become increasingly rare.  Those who stick with the old way of investing using buy and hold are akin to the military commander fighting the last war.  Investors must adapt to the ever-changing investing environment, and that environment today demands more active management, flexibility, and a new way of thinking regarding the use of cash as a true asset class within all portfolios.

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