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5 Things to Do in a Correction

By:   Slav Fedorov
  • 17-05-2009
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When the market stalls and rolls over, there is no shortage of predictions of what's going to happen. The reality is: nobody knows. These things tend to feed on themselves. Sometimes the market will just shake off a bad spell and continue higher. Other times it will gradually succumb to the selling pressure and cave in. But you can't tell in the beginning how long a correction will last or how bad it will get. How can you, if the market's direction is shaped by future events that have not yet occurred?

So what can you do in a correction?

1. Sell early or don't sell at all

You never know which stocks will correct and which will hold up. In a severe downturn, virtually all stocks will go down with the tide. One by one. Hoping that YOURS will buck the trend is a poor investment strategy. If you decide to tough it out, eventually the pain may become unbearable and you will sell at the bottom. Why? Because most people have similar pain thresholds which they reach more or less at the same time. After they sell, there are no more sellers left, and the market has nothing else to do but turn back up.


2. Watch for rotation

Every new leg up is powered by a new crop of leaders. A correction is often a rotation from one sector into the next. Institutions take weeks or even months to build and unwind positions. They also have to operate on a cash basis. If they are fully invested, they have to sell first before buying something else. In a stampede they sell all at once, often the same stocks, depressing prices and causing severe breaks in the market. Why shouldn't they? The managers all went to the same schools, studied the same economics, read the same papers, and watch the same CNBC. But institutional selling has a silver lining (for them): it depresses the prices of ALL stocks. So when they are finally ready to deploy the cash, institutions can get a good price on the new positions.

Rotation is one of the reasons you should take your profits regularly. If you buy and hold, you risk getting stuck with past leaders that will languish for years, or, worse yet, break down, while the new ones pass you by.


3. Determine who your friends are going forward

These days it does not take long to buy or sell a stock. After you lock in your profits (or save your shirt) most stocks will go down in a correction. Some WILL buck the trend and go higher. Don't let the exception negate a sound rule. You don't know which stocks will hold up. But the ones that do are likely to do well in the next leg up. If you have to buy them back higher, consider it the cost of insurance. Smaller gains are still better than losses.

Another thing that happens in a correction is that breakouts dry out. But the good stocks, like the good businesses they represent, don't vanish. They just wait. So should you. The longer the base, the stronger the eventual breakout.


4. Keep your powder dry

If you try to buck the trend, you will get burnt. You will feel frustrated and exhausted by the time you SHOULD be getting back into the market. If, on the other hand, you wait out the correction in cash, you will be ready for action way ahead of the crowd.


5. Short/hedge

The alternative to cash is shorting. There are good longs and good shorts, but to my knowledge few are equally good at both. But you can always use a short ETF just like you would any other long position.

Content Provided by:
Slav Fedorov


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