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Benefiting From the Correction

Doug Kass

How to Set Up a Short Book to Benefit From a Correction
1/29/2007 10:21 AM EST

Over the last week I have received a bunch of emails that ask basically the same thing: If you are growing increasingly cautious -- as you expressed in a recent column (the notion that January 2007 is beginning to more closely resemble the conditions of January 1994 -- how do you change your short book to benefit from a correction?

Here is the answer: When times are a changin', I increase my short book by puchasing puts and I move my short book toward higher octane, more volatile stocks, like I did this morning with Chicago Mercantile (CME).

Getting Technical
1/29/2007 7:59 AM EST

Back in 1972, Yale Hirsch devised the January barometer, which basically says that as January goes, so goes the year. According to Hirsch, the January indicator has been an accurate predictor more than 91% of the time. Only in 1966 and 1968 (the Vietnam War impacted markets), 1982 (the start of the great bull market), 2001 (the World Trade Center attack) and 2003 (the start of the Iraq conflict) did the January barometer fail to predict the full-year market direction.

January 2007 is not yet in the books, but with a year-to-date gain in the S&P 500 of 0.29% it could go any way.

Another barometer is pre-(presidential) election years. There have been 16 pre-election year gains in a row since 1939, serving to tilt the odds toward a positive 2007 for equities. However, there have been large corrections in several of those years (1971 -16%), (1979 -11%) and (1987 -36%). Complicating this further is a calculation done by Chase Investment Counsel that in normally favorable pre-(presidential) election years since 1856, there has been a substantial decline in every decade starting either in the sixth or seventh years -- averaging 24% with the smallest totaling 15%.

So if you were to take these historical patterns as gospel, it suggests the probabilities might favor a gain for the major indices this year, but also, most likely, a market that is accompanied by a meaningful correction at some point in time.

I love the voodoo that Hirsch does so well.