Market corrections often show up in threes, just like a Tsunami.  As of this writing, the various stock market indices are hitting new highs daily; it is hard to believe that a month ago the press was screaming about an impending bear market.  Yes, the Press does like to sensationalize the news; and in this instance, we don't agree with a bear market, but we do believe in healthy corrections.  When we say correction, we mean a drop of better than 3% in the major stock indices. 

Visiting Gold Lake in Colorado after the tsunami, I had the pleasure of meeting a couple who survived the experience that devastated Thailand.  Besides discussing the harrowing event, they mentioned that tsunamis create a three wave action.  The first wave is small and ominous; it is larger than most but not gigantic and then it pulls back leaving more beach exposed than the regular waves.  The second wave is also larger than normal and the third wave is often the terror that causes all of the damage.  Now, in reality there can be multiple waves, not just three but for our purposes and clarity we will keep our discussion to three.  The husband of this couple that survived the Thailand Tsunami miscounted the waves; after the third wave hit, he was separated from the rest of his family and stayed on the roof of a neighboring home.  He remained on the roof for hours waiting for the third wave to come before he realized that the third wave had already passed.   

The tsunami pattern can be applied to the stock market.  In fact, this type of correction has a name: it is called an A-B-C correction.  The A in our present ABC market correction came on February 27^th.  The stock market declined more than 1% that day.  That same day witnessed the Chinese government raising interest rates in an attempt to slow their over heated economy.  This event was the catalyst for the first correction in more than a year.  The combination of sub prime mortgage market meltdown and interest rates rising in China sparked a panic.  The stock market in China dropped approximately 9% prior to the US market opening. 

In the US, interest rates did not rise, the job market stayed the same and the fundamentals were no different from the prior positive day on Wall Street where the Dow recorded another record high closing.  Applying Integral theory, the lower right quadrant relates to the macro systems in place February 26^th until the writing of this article, they have not altered at all.  Interest rates are basically the same; the money supply has not significantly changed.  Economic production remains about where it is expected to be.  Unemployment and business profits are also meeting predictions.  Yet, the perception (upper left quadrant) on the same dates (February 27^th and for several weeks thereafter) indicated that something dramatic had changed for investments.  This change in perception triggered by the drop in Chinese stock market resulted in a one day drop in the major US stock market indices (upper left perception resulting in an upper right action).  So, the perception, left side of the quadrant, had the immediate effect of changing the upper right quadrant for investors.  Investors sold their equities.  The change was swift and dramatic and the we space (lower left quadrant) for a large group of investors shifted from trusting the market and feeling the reward of stock investments to mistrust of the market and the feeling of harm in their wealth.  Please note that a belief held by a large group of people belongs in the lower left quadrant; and their psychological reaction creating a dramatic sell off happens in the upper right.  The psychological belief by many investors on the 27^th of February precipitated two things: equities in one day lost 3% of their value and interest rates declined as investors sold their equities and invested in cash.

From February 27^th through about March 18^th the indices moved erratically before resuming upward momentum as the reality set in of a relatively stable job market, inflation, interest rate environment and business profit outlook continued to look bright.  Interesting to note, these systems are all lower right quadrant factors that never changed during this period of stock market uncertainty. 

Continuing with our alphabet theory, we entered the B wave starting with the low point in mid March, with anxiety about an accelerating decline. Naturally that period of time was the height of the panic.  The left half of the quadrant was quaking with fear and the right side reflected the fear by a spike in short interest and put premiums.  In mid April, the B Wave was felt in full force.  Amazingly, the financial media, which only a few weeks ago latched onto the B word (Bear Market), is waxing eloquently about the market shattering new highs on the Dow and the S&P 500.  As luck would have it, our article about Fear was published just as the B Wave commenced. 

Our current wave with A and B has been impressive. The S&P 500 has tacked on almost 150 points to break the psychological 1500 level; stock prices for all three major indices have surpassed their highs of the year. All the ill-fated short bets have shaken out.  The financial media has forgotten the worries of March.  Even so, we continue to have the same systemic issues overhanging the equity market and our economy, namely:

• 1) China's economy is on the verge of overheating so the Chinese government will need to raise rates again.
• 2) Issues with the housing sector continue and the fundamentals for housing are deteriorating.
• 3) Corporate profits are in question. Will they continue to grow as they have for the past couple of years?
• 4) Retail sales have been much weaker than expected.
• 5) The slowing trend in retail should continue because the ramifications of a slow down in housing means that big ticket purchases to furnish those homes should also decrease.
• 6) A retail slowdown combined with a reduction in automobile sales heading into the summer season, leads us to anticipate a slowdown in the general economy.

All of the above factors point to the equity market being stable at best rather than catapulting towards new highs as it has recently.  Given these factors, we expect the C Wave to hit sometime in the next few months.

Just as the gentleman miscounted the Tsunami waves, many seem to have miscounted our current A-B-C Wave.  At the moment, interest rates are poised to level off at current rates, job growth is continuing at a stable level and the softness in retail sales and the housing market is helping to prevent a rise in interest rates. 

The above scenario is perfect for the C wave to come thrashing in upon the unsuspecting.  Not that we predict markets, because we do not, but sometime after Memorial Day, when volume is historically lower due to the beginning of Wall Street's summer vacation, we would not be surprised if bad news from China, the Middle East, retail or the housing market triggers a dramatic sell off.  Just as in February, some shock causes the indices to plummet 3% or more in a day or more than 5% in a week. 

Below is a chart Nasdaq Bullish Percent Index (BPCOMPQ) showing three significant transitions from correction to bull rise over the past three years of the current bull market.  The BPCOMPQ indicator is a simple measure of overbuying or overselling in the stock market.  The A wave of this correction started shortly after the BPCOMPQ reached overbought levels above 60 at the end of February.  The B-wave bounce rallied the indicator a bit to approximately the 55 level as of this writing. 

From an integral perspective, please notice how the perception of something bad quickly results in sales which eventually move the entire market lower.  In this chart, the oversold positions correspond nicely with lows in the various indices and the overbought situations correspond nicely with relative stock market index highs. 

Notice how quickly sentiment changes from bullish (over bought) to Bearish (oversold).  The economic conditions throughout this period were positive to stable.  The changes cannot be explained by changes in economic conditions.  These changes are purely due to psychological perceptions of the future by investors. 

Notice also that the three previous springtime corrections ended with the BPCOMPQ well below 40.  The lowest the indicator dropped this spring was to 52.  So, it's quite likely we'll see another wave of selling push the BPCOMPQ lower (below 40) and set the stage for a decent rally later the year.

As a result of our understanding of reality vs. theory, we favor actively managed portfolios over index funds, select stocks and individual bonds which in general result in superior performance.  The superior results are explained and expected by integral theory. 

We continue to follow the current economic trend with interest.  Short term variation only assists less than 20% of the population in short term trading investment management.  The vast majority of the population loses.  What interests us most and the reason for writing this article is noticing and highlighting the influence of irrational investment behavior, noted on the left side of the quadrant.  Using integral theory, we can transform investment management, noted on the right side of the quadrant, to a new integrated level, which results in greater financial success.