Stocks Are Down? It's About Time!

Are stocks finally beginning to correct the monster rally off the March bottom? I think so, and all that surprises me about it is that it has taken this long.

There are a number of reasons why it was inevitable, and why we should welcome it, assuming it has indeed arrived.

As I wrote here earlier this month, the rally, delightful as it has been, is a case of too far too fast. Sure, what goes down must bounce up.

From the October 2007 top to the March 2009 bottom, we endured a loss in stocks of 57% over 15 months. Since the bottom, we've had a rally that reached as high as a 58% gain in about six months.

The last time anything this spectacular happened was 75 years ago coming off the very bottom of the bear market in the Great Depression. At that point in 1932, stocks had lost 86% from their 1929 highs, spending almost 1,000 days getting there. We didn't fall that far, thank God, so we just don't have as far to bounce back.

When a rally gets as overextended as this one has, it becomes vulnerable to even the slightest bad news. Just about anything can trigger a correction to more sustainable levels.

In fact, an overextended rally is even vulnerable to good news. Remember, it was the sudden change in investor psychology from expecting bad news to expecting good news that caused the rally in the first place. You know the old saying: buy on the rumor, sell on the news. In investing, all news is old news.

What can keep a rally going is when the news is so good that it exceeds expectations. That's easy when expectations are set low. Upside surprises are easy, then. And every one of them drives stocks higher. But the stock market is a learning machine. As each new upside surprise arrives, investors raise their expectations higher and higher. Finally, the news just can't be good enough to surprise anymore. In fact, it ultimately disappoints.

Just look at the not-so-hot economic news that's come out over the last week or two. Friday morning's disappointing payroll jobs report, Thursday's worse-than expected initial jobless claims, a falling ISM Index, disappointing new and existing home sales, falling durable goods, lower-than-expected consumer confidence. Some of these have been objectively good numbers, and those that weren't so good are still a heck of a lot better than they were six months ago. But every one of them fell short of consensus expectations. So now expectations get realigned a little lower, and stock prices do too.

And then that feeds back into the biggest expectation of all -- the expectation that it seems so many investors have had that a rally this powerful simply has to keep going. Pretty silly, huh? Seems to me that the higher stocks go, the less room there is for them to rise in the future. But just about everyone I talk to has felt, over the last month or two, that rising stock prices necessarily beget more rising stock prices.

So when stock prices fall, even a little bit, a lot of people who had unrealistic hopes suddenly get scared. After what we've all been through the last year or so, some pretty serious fear still lives just below the surface. And when that kind of fear gets activated, the people who really had no good reason to buy suddenly feel they have a compelling need to sell -- and they do just that.

This expectations game could kick into high gear this month as earnings season revs up. The last earnings season, which kicked off mid-July, was all about upside surprises. The average company beat expectations by almost 15%, the best performance in more than two years. That was key to kicking off the monster rally we've had.

But those upside surprises were made possible by very low expectations. It's not like earnings actually went up last earnings season -- they didn't. They went down to new lows, but everyone was thrilled because they didn't fall as much as expected. Thus a smaller downside equated to an upside surprise.

That's been enough to cause expectations to be revised sharply higher. Consensus earnings expectations are now 7% higher than they were three months ago. We're going to need to see some companies post some actual improvements this month. I'm not saying they won't do it. I'm just saying that if they don't -- or if they do, but it's not as much as hoped -- investors will be very disappointed and this correction will intensify.

Don't think it can't happen. Six months ago it was fashionable to assume that nothing could save the economy, and that we were headed straight for a depression. Suddenly it's fashionable to assume that everything is hunky-dory. The fickleness has been transformed -- rationalized, actually -- into an investment strategy: The worse the decline, the better the recovery.

To some extent that's true. When you create a low enough base, any recovery at all seems like a lot in percentage terms. That's what's happened with stocks. We had a 58% decline, which set up a nice low base from which we have had a 58% rally. But anyone with a 401(k) plan that's still decimated can do the math. When you're down 58%, you have to go back up by a lot more than 58% to break even. In fact, it's 138%.

So from a low base you can get a lot of illusions that make you feel really good even when things are still really bad. I'm not trying to pooh-pooh this economy recovery -- I definitely think the recession is over, and that we are indeed recovering. But it won't be easy and it won't be fast.

Recovery will keep happening. Earnings will come back. Stocks will rise. That is all to say that things will be better a year from now than they are today, in the economy and the stock market. But when you're an active investor who looks for what to do every single day, for me the best short-term play is still to expect some downside.

If I'm right on both counts -- that is, first things go down for a while and later they go up -- then this correction I expect will just be a correction. And here's my advice. Just when everyone starts telling you that dropping stock prices means the recession is still on, or that we're making a "double-dip," that's when you want to buy stocks for the next leg up.

It's all about expectations. You have to buy them when expectations are low, and sell them when expectations are high.