The Market’s Due for a Correction: How to Play the Decline

Source: Thinkstock

Source: Thinkstock

Thursday was a rough day for investors as the stock market fell 2 percent. For many this appears to be the start of a long-awaited correction: stocks have risen relentlessly for the past couple of years without any significant correction, and we have been hearing calls for such a correction for some time now. Not only that, but the stock market is historically overvalued. The S&P 500 trades at a whopping 22 times earnings, while it has historically traded at about 12-15 times earnings. Furthermore, it pays a paltry dividend yield of just 1.8 percent despite the fact that historically it has yielded an average of over 4 percent.

So I think that the market is due for a sizable correction, but have we begun to see this correction, or is this just a blip before we move higher?

Despite the fact that I am bearish of stocks, I do not think that we have begun to see the major correction that investors have been anticipating. I think that we will hit a bottom in this mini-correction in the next few days and we will continue to move higher. The reason for this is that the Federal Reserve is continuing to provide support to the bond market to the tune of $25 billion per month. While this may not sound like a lot compared with $85 billion, it still means that the Fed is increasing the money supply by about 0.5 percent per month, and that is pretty substantial.

This is generating demand for bonds. As bonds rise and yields fall, it follows that stocks appear more attractive by comparison. With this in mind, I think we can see further demand for stocks, especially since low interest rates will incentivize corporations to borrow money in order to buy back stock. So this can generate one last boost to the stock market. But when the Fed finally stops its tapering program in October I think the stock market will fall.

What, then, is the appropriate strategy?

First, off there are some good values remaining in the stock market. Look at the ongoing correction as an opportunity to take positions in these stocks. For instance, there are a lot of very inexpensive stocks in the integrated oil space [e.g. Chevron (NYSE:CVX) trades at just 12 times earnings]. If you rotate out of some of the high flier stocks and into inexpensive names such as Chevron you can avoid the severe losses that we often see with high risk stocks in bear markets.

Second, if you are a trader and a bit of a gambler, then you can use the sell-off to take a trading position in the S&P 500 via the SPDR S&P 500 ETF (NYSEARCA:SPY). You may also consider buying the Nasdaq via the Powershares QQQ Trust ETF (NASDAQ:QQQ), although this is a bit riskier. I suspect that after the correction ends that we can see new highs for this bull market. But make sure to use stop order and to take profits when you have them.

Third, you should look for opportunities to take profits. I know it is difficult to sell a stock that is moving higher, but keep in mind that most stocks are historically overvalued. Now is a good time to hold some cash, very inexpensive stocks, and some gold.

There is no guarantee that you will pick the top in the market, and it is possible that we have already seen it. The point is that stocks are historically overvalued and that a lot of money is flowing out of stocks as investors prepare for the end of quantitative easing. I think it is wise to follow suit, but be tactical rather than rash.

Disclosure: Ben Kramer-Miller is long Chevron.

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