The Case of the Overdue Correction

One oddity of the move off of the prewar lows in 2003 is that the S&P 500 has yet to have a 10% correction. During the bull market period from 1996-2000, there were six corrections of 10% or more. Since the bottom on March 5, 2003, the S&P has sustained only three corrections of more than 6% and none greater than 9%.

Regular corrections serve a purpose for healthy markets: They cleanse the excesses that tend to develop, allowing further gains to proceed.

The lack of a 10% correction reveals high levels of complacency -- something the CBOE Market Volatility Index (VIX) has been implying for quite some time. This creates "air pockets" -- soft spots in the base of support that can potentially become more vulnerable to selling in the event of a test. As the 1966-1982 chart shows, broad trading ranges typically experience much greater than 10% corrections. Considering how regularly markets pull back and test support, the longer we go without that 10% correction, the greater the possibility of a steeper and deeper downturn.

The suggestion of a 30% fall in the S&P 500 has engendered widespread disbelief; investors broadly discount the mere possibility of such a correction. But as the nearby chart shows, there were five corrections that ranged in strength from 25% to 45% from 1966 to 1982. That averages out to one major correction every 38 months or so.

The S&P's last major correction was a 33% drop from March to July 2002. That was 42 months ago -- implying we are overdue for another steep decline.

Structural Imbalances Create Vulnerability

Past crises such as the Asian currency crisis and the Long-Term Capital Management meltdown were able to be managed because of economic strength. When they occurred, markets were in the midst of a bull run and the economy was growing organically. The Fed had lots of room to add liquidity. The economy shuddered a bit, but handled these shocks well.

Ups and Downs
The 1966-82 experience says we may be in for violent moves down and rapid blastoffs
Source: Rydex Funds

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