Making Money Alert: Volatility is the Precursor to Correction

The fear trade is back on Wall Street. With the events of the past three days, it’s no wonder why.

The Boston Marathon bombing, and then ricin-laced letters to at least one Senator and to President Obama, would alone be enough to cause sellers to run for the exits. Then when you combine these exogenous events with the meltdown in gold, silver and other commodities, you get a recipe for some real selling in stocks — and some real volatility.

For months now, I have been calling this market overvalued, overbought and overloved. When this trio is present, just about any kind of tripwire will set off a flood of volatile trade. We saw that on Monday with the huge down day for gold and stocks, some rebound buying on Tuesday and a big sell-off in stocks today.

I want you to make sure you understand that often, volatility in the markets is a precursor to a correction. With the volatility of the past week in both stocks and commodities, I suspect that a significant correction isn’t far off.

I think the price action in stocks in the days and weeks ahead will tell us if this week’s retreat is indeed a correction or just a little short-term volatility. If we do see a significant pullback in stocks, I think that situation will present investors with the first real, low-risk buying opportunity in nearly six months.

One thing to keep at the forefront of your mind going forward is that the markets historically have rushed out to a fast start in the first part of the year, only to give it all back midway through the year.

I recently crunched some numbers and noticed that in every single year dating back to 1990, the Dow Jones Industrial Average has reverted back to its January opening value at least one time during the year. In some years, that reversion has taken place more than once.

During the last several years, this trend really pops out at us. For example, in 2012, the market came out of the gate strongly. Through the first four months of that year, stocks in the Dow climbed some 8.7%. Unfortunately for ebullient bulls prematurely celebrating that win, May 2012 was a disaster, with the market tumbling 8.75%.

The same thing occurred in 2011, with the market jumping out to a 10.7% gain through the first four months of the year. Then in the succeeding three months, stocks gave back all of their gains and by early August the Dow had fallen 11.1%. This curious situation happened yet again in 2010, where stocks came out of the starting block strong with a 7.4% gain through April 26, only to see that gain evaporate by May 7.

Now, many market watchers are comparing the current market environment to that of 1998, when stocks began the year strongly. In that dot-com bubble year, the Dow raced out to an 18% gain through July 17. Then from July 17 through the end of August, stocks in the Industrial Average tumbled 19.2%, wiping out all of its gains during the first seven-plus months.

In markets, past is often prologue — and volatility often is the precursor to correction.

The Damage Done

While the focus on U.S. stocks has been rightly the subject of investing news during the past few days, the real financial news around the world is the meltdown in gold and China.

Let’s take a look here at three charts that tell the tale better than any verbiage.

As you can see by the chart here of the SPDR Gold Trust (GLD), the plunge in the yellow metal has been both drastic and destructive for those who own it. So far in 2013, gold prices are down more than 18%.

Meanwhile, data out of China confirming a slowdown in the rate of gross domestic product (GDP) growth has exacerbated the selling in Chinese equities. Shares of the iShares FTSE China 25 Index (FXI) now trade below both the 50- and 200-day moving averages, and are down more than 17% year to date.

As you can see, the damage already has been done in gold and China. And while these two sectors may at some point begin to look like attractive buying opportunities, right now your best bet is to stand aside and avoid the carnage until things settle down.

Don’t Believe the Hype

Used, abused, without clues
I refused to blow a fuse
They even had it on the news
Don’t believe the hype

–Public Enemy, “Don’t Believe the Hype”

There’s a lot of rumor, speculation and conspiracy thinking running rampant in the news right now, and I guess that’s to be expected — given the terror events of the past three days. This obviously is affecting the markets as well, but words of caution here are in order, and those words are “Don’t believe the hype.” Take a deep breathe, read and study, but don’t panic or jump to conclusions. The facts will come out soon enough. Until then, do what you should do to protect your money, and your family, from the normal threats that are present each day.

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