Ready for a Retest?

Forget the bankruptcy of General Motors, the plunge in the dollar, the widest two- and 10-year Treasury spread in history or the biggest monthly gain in commodities prices in a quarter century. The market rally continues unabated and unabashed. Indeed, the S&P 500 is up 40% from its early March low.

But stocks have never moved in a straight line, especially through recessions and recoveries, causing many market professionals to brace for a 10% correction or -- horrors -- a retest of previous lows. A retest is a technical term used by pros who track the stock market with sophisticated charts and graphs. The argument goes that stocks can scrape along a bottom vs. bouncing off of it, leading to mini rallies that are inevitably followed by pullbacks to where the market traded last week, or last month or last year. These up-and-down swings are typically referred to as “W,” “V,” “L” or “U” shaped recoveries. 

As scary as a retest may sound to investors still grappling with the carnage of the last 18 months, market pros say it's actually a good thing. Shaking out the speculators, exhausting the price momentum and getting good stocks and exchange-traded funds on the cheap are critical to forming the bedrock of a more sustainable rally. History also shows that corrections and retests always occur before bull markets start to form. It may be painful to see your account balance shrink, but it's all part of the recovery process.

Fortunately, there are some very simple, tactical moves investors can make to prepare for the plunge, which looks more likely with every passing day. After all, there's a lot of money sitting on the sidelines waiting on a pullback before being deployed, says Dean Barber, president of Barber Financial Group of Lenexa, Kan. "If we don't get a pullback we might be limited to a 9700 range on the [Dow Jones Industrial Average] because there are no fundamentals behind this rally; it's all emotional."

As the Dow nears 9500 to 10000, nervous investors will cash out, Barber says. But if we have a retest back to around 7800 in the interim, that will pull cash into the market, setting it up for a more sustainable run.

Douglas De Groote, managing director of United Wealth Management in Westlake Village, Calif., says the rally is "scaring the heck out" of him. "From a technical standpoint it's way overdone," De Groote says. "We are definitely poised to retest. There's some gambling going on. Lots of people are trying to position themselves in the short run to make up everything they've lost in the last 18 months."

A scenario where the Dow Jones Industrial Average returns to the low 7000s over the ensuing months is not difficult to imagine, says De Groote, as mutual funds and institutional investors stop chasing returns -- and the dim realities of economic and corporate fundamentals once again hold sway.

Jason Trennert, managing partner and chief investment strategist at Strategas Research Partners in New York, says there's a little bit of a sense of false prosperity at work. "We're subsidizing mortgage rates and effectively subsidizing the economy," he says. "For now more people are worried about being short, or underinvested, than being long, or overinvested." That's helping fuel a rally that could very well whipsaw back on investors' portfolios.

"If you're going to be an investor in equities I would say you have to be very careful using a buy-and-hold strategy right now," Trennert says."The volatility of the economy is going to be significantly higher."

On the slightly brighter side, as the market makes higher highs, it's also likely to make higher lows on any retest, says James Dunigan, chief investment officer of PNC Wealth Management. "As we inch our way up, I think our support level and the level at which the market may test on the downside might move up as well," Dunigan says. "A 5% to 10% move to the downside would not be unwarranted."

But if a correction, retest or full-blown plunge seems an inevitable and ultimately good thing for the market, what's a lone retail investor to do? Protect your gains and keep your allocations in check, say the pros.

"Being defensive is not a bad thing," says United Wealth Management's De Groote. "You want to participate as long as the market is going up, so protect yourself with your stop-loss orders." For example, if you bought a stock at $50 with a stop-loss of $45 and those shares are now worth $70 (a 40% gain), roll up your stop-loss by the same percentage -- in this example, a stop-loss at $63. "Don't be afraid of being stopped out," De Groote says. "This forces you to sell higher."

Finally, don't forget to check that your allocations aren't out of whack. If the recent run in tech stocks has caused your tech allocation to grow to, say, 20% of your portfolio from 10%, redeploy or book those gains. After all, as De Groote says, no one really knows whether this will be a "V," "W," "L" or "U" shaped recovery for equities, only that it will retrace some sort of pattern -- and it behooves investors to be prepared.