Correction red alert: to short or stay in sidelines?

September 22nd, 2009

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As you read the chatter from the various financial sources, you will get the sense that there is an increasing expectation of a major correction. Unfortunately, if you take this as a sign to short the market, it can result in losses. For example, this month began with what looked like the beginning of a correction that turned out to be a false signal. The most substantial correction (of less than 10%) since March 2009 occurred in June.

Therefore, the moral of the story is: if you try to pick the exact market top (or bottom), be prepared to be wrong and lose money as a result. If you happen to make money, attribute it to luck.

But there is at least one thing you can do (or rather not do) at where you believe to be the top: stay at the sidelines. To be a successful investor, you must not be pressured to trade continuously. Good investors trade when the market presents an opportunity, not because they have to be in the market to ‘optimise’ their gains. However, if you choose to try your luck at picking tops (and bottoms), at least make sure you are hedged (e.g. with options) and not exposed to unlimited losses.

If you decide to stay at the sidelines, you can be sure that you will be at least in good company with company insiders (pun intended). As Insiders sell like there’s no tomorrow reported,

Biderman, who says there were $31 worth of insider stock sales in August for every $1 of insider buys, isn’t the only one who has taken note. Ben Silverman, director of research at the web site that tracks trading action, said insiders are selling at their most aggressive clip since the summer of 2007.

Silverman said the “orgy of selling” is noteworthy because corporate insiders were aggressive buyers of the market’s spring dip. The S&P 500 dropped as low as 666 in early March before the recent rally took it back above 1,000.

Insiders may not be good stewards in handling their companys’ money, but when it comes to their own money, they are pretty astute. This is a good sign that the stock market has ran ahead of the fundamentals and is in bubble territory.

In a report from David Rosenberg (an astute bear), he concluded that by now, the ones who are still buying into this rally are

Very likely it is still a combination of program trading, short coverings and portfolio managers desperately trying to make up for last year?s epic losses.

He added that,

The market is so overextended that it is now 20% above its 200-day moving average, which is a technical condition that has not occurred in 27 years.

Also, as we wrote in Are institutional investors courting financial losses?,

As you can see, at 84.47% the bullish sentiment is at an unprecedented high level.

Another sign that we are in bubble territory can be found in the bond market. As High-Yield Bond Buying Starting to Get “Ridiculous” (Update2) reported,

Investors are buying bonds from the lowest credit-quality issuers without restraint, according to Citigroup Inc.

Yields on high-yield, high-risk debt have narrowed by 80 basis points relative to benchmark rates in the past two weeks, Citigroup analysts John Fenn and Jason Shoup wrote in a Sept. 18 report. Last week, 13 companies, including casino owner MGM Mirage and video chain Blockbuster Inc., sold more than $6.5 billion of bonds, they wrote.

If you still want to try your luck at picking the market top, you may want to check out what our friends at Market Club have to say about the current market conditions: Two Major Technical Forces About to Collide. Basically, October is the technically significant month to watch out as they expect the S&P to correct sideways at best (or even downwards).

October is also the month in which celebration of the 60th anniversary of the founding of the People’s Republic of China ended. We could be wrong here, but our vibe is that Black Swans (or maybe grey ones) may arise from China.