Carr's Call: Five ways to spot a correction

Nervous about a market correction? There are five key signposts you need to watch.

Summary: Market corrections often come as a surprise, but there are a number of ways to pick the correction trend. These include tracking various indices, financial market spreads, and keeping a close eye on the news.

Key take-out: Sharp and prolonged movements in key market indicators generally signal that a significant correction is ahead.

Key beneficiaries: General investors.  Category: Portfolio management.

All rallies make investors nervous, especially when they are like this one, which caught a lot of people off guard.

Just because it’s a ‘surprise rally’ doesn’t make it new or anything. For the US it’s in its fourth year. It’s just a lot of people didn’t expect it to continue given they had very pessimistic outlooks on Europe, the global economy and markets in general, and confused normal cyclical slowing in the data mid last year with something more ominous.  That many analysts have had to do a 180-degree turn is probably a key reason why we constantly see calls for a correction now. I mean, corrections happen, markets go up and down, but the call more recently has been especially vocal and persistent – and as yet a correction is lacking.

Now, I’m bullish, you know that, and you know the reasons why. But corrections happen, and so the trick for investors is to know when correction talk might just turn into a correction walk – luckily, there are five key indicators that we can turn to for help.

By my reckoning we’ve had three significant corrections – 10% or more – since 2010. The first was from about April to August 2010 (of about 15%), again from July to November 2011 (of about 17%) and then a smaller one from April to June 2012 (about 10%). In each case, one or more of the indicators below was a good signal investors could expect something other than a modest retracement.

  1. The VIX index

The VIX index, shown in chart 1, is a volatility index – effectively the implied volatility of S&P500 index options, over the next 30 days. It’s become known as the fear index because when fear rises, volatility lifts. And you can see that on chart 1 below, when volatility surged around each of the corrections noted above.

The way I would look at this index is as a measure of how seriously the market takes a particular fear event. And the advantage of it is that it’s broad. It covers a lot of known unknowns and unknown unknowns. If you see stocks falling and the VIX rising, then there may be something in the fall. So if you look at each of the big corrections above, the VIX was sustained around or over the mid 20 mark for some time – for months even. Contrast previous fear episodes with the fiscal cliff at the end of 2012. The VIX barely budged, and when it did rise – on one day only to about 23 – it lasted one session, before falling sharply again. This was a clear signal that there was unlikely to be any correction, as disappointing as that was for many of us.

2.Talk of QE ending

I wrote about this in my February 11 note, QE plug won’t be pulled. I don’t think the Fed has any intention of pulling QE, no matter how good the economy or rally is, until the budget deficit is in order.  That won’t stop talk of it though and, as I’ve highlighted to readers before, it was talk of an end to QE in 2011 that helped see the S&P500 off 10% or so on two occasions (Around mid-year and later in the year as well). Note the VIX index was elevated for the entire second half of 2011, because markets were on edge for a long time.  Anyway, after I wrote that article, the drum beat of a QE end did get louder, but I was surprised at the speed at which Federal Reserve chairman Ben Bernanke et al acted to dampen speculation of it. Still, I’ve seen a number of press reports talking of a possible Fed interest rate hike this year. Just keep an eye on it – look for the frequency of articles and whether these articles gain any traction or acceptance in the broader investment community.

3. Italian & Spanish bond spreads

There’s lots of talk that the Eurozone crisis isn’t over. Well, if that’s true (even if it’s not I guess), this indicator and the next are crucial – they’ll cover you for most conceivable events in Europe, social unrest and the like. If there is a problem in Europe, it will manifest in these. Chart 2 shows the Italian and Spanish 10-year yield less the German 10-year bund.

This is the best measure or indicator to determine whether European sovereign concerns are likely to smash the broader market – the two stockmarket corrections over the 2011-2012 periods are shown by the shaded areas.  You’ll note from the chart that it’s not so much the level of the spread as such that indicates a correction, because spreads are still very elevated right now. It seems to be the rate of change of that spread – i.e. look for a surge in the spread. For instance back in 2011 when the Italian spread to bunds was actually lower than it is now at 176 basis points, it then shot up 120bp in the space of a few weeks, which sparked some alarm. It’s the same story in 2012. A 100bp surge in the space of three weeks preceded a stockmarket plunge. The Italian election of 2013 was close, but different. We did see a spike in yields – a 90bp spike. But it took a couple of months and wasn’t accompanied by either a spike in Spanish yields, nor any movement in the VIX index.

4. Three month Euribor-Overnight Indexed Swap spread

During the GFC this spread and others like it – the three-month Libor-Overnight Indexed Swap spread (OIS) – were watched closely as a sign of troubles in the inter-bank lending market (that is lending between banks). Recall that during this period, banks were so unsure of each other’s solvency they refused to lend to each other.  So, for instance., the yield on Euribor, which is the rate at which European banks lend to each other, pushed higher, even as the central bank cut rates, and markets priced more cuts (indicated by the OIS). So this spread can be used as a gauge of European credit conditions– solvency and the like. Europe is still on everyone’s mind, and some remain especially concerned about bank solvency. So watch this spread. If it blows out, like it did during the second half of 2011 again, there is a problem. Currently the yield on Euribor is low at around 0.2%, and so the spread is quite low. Calm prevails.

5. The US ISM manufacturing index

I’ve put this indicator in as the only fundamental indicator – that is of the economy – because it’s one of the few leading indicators (leading of economic activity) I think investors should take seriously. And, of those, it’s the best. It’s not perfect mind you, nothing is, and it can give false signals, but if stocks should fall on US growth fears and you want determine whether that will turn into a proper rout – then this is the index to watch. Don’t get spooked by just one or two months where you see a fall. You need to see a fall to 47 or below to be worried. Markets do move on less, but for a correction to persist, sparked by only fears of a slowdown or what have you, you really need to see this go below 47.

There are plenty of other indicators that some people look at: China’s Purchasing Managers Index, index data from the Economic Cycle Research Institute and the like.  I haven’t included them because, quite frankly, they aren’t very good. They get a lot of media interest but I wouldn’t use them as an economic signal. Unfortunately, there is nothing we can look at on China.

To conclude then, these indicators will pretty much guide investors to the seriousness or otherwise of a downward price move on stocks. The list isn’t exhaustive, but it should cover us for most eventualities. They cover the major risks that we know and even those, especially through the VIX, that we don’t. If you don’t see any significant movement in these, then, chances are, you’re just witnessing noise.