It is an amazing 2014 already.  In just a little over a month, the prior euphoric 18 months have been wiped from the collective memories of market participants.   The fear / greed index as measured on CNN Money collapsed from 68 (greed) at the beginning of the year to 13 (extreme fear) at a recent close of the market.  I have to acknowledge one stumble of the index in the middle of 2013 after the Federal Reserve began to discuss tapering. However, this was dropped from our memories as the market subsequently bounced back to have a strong finish to 2013. 

Economic data has emerged as being mixed right at the time the Federal Reserve has begun implementing its tapering program (i.e. the amount of bond buying as part of the methodology they were using to stimulate the economy).  The question everyone is now asking; “Will they stop tapering for the time being to bring stability in the markets?”

The poor performance of the market to start February hasn’t occurred since 1982 for the Dow Jones and 1933 for the S&P 500!!   This, combined with the fact that the US Treasury 10 Year Bond has witnessed a drop in interest rates from 3.00% to 2.60%, when everyone was expecting them to head to 4% in 2014, results in an intriguing situation.

Unfortunately, the net effect of this situation has precipitated a rather violent decline in the value of foreign currencies in relation to the US dollar.  This decline has created a dramatic sell off in various assets classes in those countries and this in turn has spilled over to the US and European markets.

Is this a correction, the start of a bear market or an indication we should we buy every equity in sight?  It just seems “too easy” for us to encounter a 7-10% correction right at the outset of the year while all the  pros were calling for one at the end of 2013.  Many companies’ earnings announcements have been reasonably good.  This lends to the theory that businesses are actually doing well despite the headwinds on the emerging market currency issues, political and geopolitical proceedings.

However if we do have a 7-10% correction, should we worry about a bear market?   This may occur since a large number of investors are complacent and it appears the Federal Reserve’s easy money policy is starting to get cleansed from the system.   Historically we have seen emerging market crises spill over and create steep losses in relatively short periods of time.  Recent historical reference examples are the Tequila Crisis of 1994-1995 and the Asian Currency Crisis during 1997-1998.   

Therefore, the potential for a significant downturn is still a possibility.  Yet, we would need to clear the 7-10% correction first and additional events would need to happen to warrant a further slide.

So what should be your investment strategy going forward?   An important concept to remember is that the “energy” expended to move the market to the upside is significantly greater than that needed to have the market decline.  This is amazing considering the market has historically moved higher over time.   What occurs during upswings is that despite many more buyers in the market there are a decent number of sellers who provide a backdrop of pressure on rising prices.  Over time enough shares are accumulated by buyers and eventually the sellers will “dry up”.  This occurs until past buyers believe the market is overvalued at which time the pressures to keep prices from rising will occur again.

Conversely on the downside, buyers vaporize as fear is a greater emotion then greed.   This lack of buying power may cause the market to drop much more rapidly.  Here are a few examples of past market moves upsides and the number of days it took to hit the starting point of that move on the downside.

Source for data in the chart above is: RealTick® EMS which is responsible for the data and the accuracy of such.

There is no way to predict which large moves to the upside will be followed by short-term rapid declines.  A perfect example is what occurred between the Summer of 2012 through the end of 2013.  Each steep 5% pullback was followed by another move higher. Therefore, this is being presented to give you a glimpse into how brutal a short-term correction can be after significant moves higher.

In order to restore confidence, the market must settle down and trade within a range to build a new base.  That might mean a move to the 1770-1810 range on the S&P 500 which it has subsequently done.  The S&P has continued to trend higher as it approaches its all-time high.

If the market doesn’t move appreciably higher, but instead continues to trend lower or has very tepid bounces, then there is a good possibility that the S&P 500 will approach 1700-1710.  If that occurs, we will have witnessed a 7% correction from the beginning of the year.  At that time we may begin to add or build new positions due to the fact that the market might become too oversold for a period of time.  However, we will approach any major pullback with some caution in the event that there is a much more thematic downturn taking place. The 1700-1710 area represents a key technical area where, historically, if it doesn’t rally from there, the market could have a much larger decline.

So, right now, we are applying the risk strategies that you have selected for your portfolio.  The recent downturn has caused some issues to be sold, which is increasing your cash holdings. Yes, everyone hates to see good stocks stopped out for losses or even gains.   We all want to hold onto the quality issues “forever”.

Yet, be assured we are maintaining a “shopping list” of quality issues to include in the portfolio with good fundamentals which also appear to be oversold. The objective is to make purchases on a position-by-position basis.  This may be done in a piecemeal fashion, or all at once, if it is our opinion they are fully discounted.   Once an issue is acquired, risk management techniques will be applied to that purchase to protect capital, in the event our analysis is incorrect.

Tom is the Founder of TRG and has been the President and Chief Investment Officer since 2008.