11/04/2013 04:52 pm ET Updated Jan 23, 2014

The Coming Market Correction in 2014

Forecasting market behavior is akin to predicting the future. This is no easy task. Most forecasts use history in order to predict what will happen and then adjust that prediction up or down with "market intelligence" in order to arrive at a forecast. Regardless of the forecasting model, it is still about trying to predict the future.

Using the past to predict the future suggests there may be some patterns that repeat. One of these cycles that the investment community pays attention to in the U.S. market are mid-term elections. We will experience one of these in the next year leading up to the mid-term election which will take place on November 4, 2014. History suggests there are corrections leading up to the election and then surges occurring after the election. It does not seem to matter which party wins or if the balance of power in Congress shifts. Here are a few examples that comment on this cycle:

"Midterm election years are historically prone to bottoms, especially in October... 2014 is also a 'fourth' year, which has the fourth best record in the decennial cycle for 132 years. Of the last four midterm election years since the start of the Great Depression (1934, 1954, 1974, 1994) that were also fourth years, only 1954 was impressive. If the 2013 bull rally powers ahead without much of a pause, 2014 becomes more vulnerable to another sizable downturn. But Almanac readers can take some solace in the fact that the Dow has gained nearly 50% on average from the midterm low in the pre-election year high." PR Web - Stock Trader's Almanac 2014

Stocks surge, on average, by a whopping 18.3% in the 200 trading days after mid-term elections, according to the Leuthold Group, a Minneapolis-based investment-research firm. Standard & Poor's 500-stock index chalked up its biggest 200-day gain, 30.5%, in 1942, as the tide began to turn in World War II. The puniest gain, 3.9%, came in 1946, as investors fretted that the economy would sink into another depression. 10-12-10

There may be up to a 20% correction in the market in 2014. There are two contributing factors to this. First, there is dropping confidence we are seeing in the market. Second is that there is a growing belief that the market is priced for perfection, i.e. over priced and any bad news could trigger a correction. There are several catalyst sub-factors that come under these major factors. They include:

  • Federal government having gone into gridlock in the first half of October 2013 defers the Federal Reserve's ability to taper buying of Treasury bonds QE3. The Fed has been on a path to raise interest rates but has had to put that on hold.
  • While government funding and the debt ceiling issues have been resolved, the fix is temporary and we could repeat the entire scenario again in January.
  • The Fed was on the path to raise interest rates but now they have stopped. Eventually, however, the interest rates will increase. This makes for a non-zero risk of inflation.
  • Lastly, there is the unknown consequences of Obamacare.

If the above is indeed the state of the market, risk-on trade is in vogue for the next 3-6 months. It may make sense to consider economically sensitive stocks. The type of stocks that could to do well are industrial, technology, base metals, and precious metals. This could help dampen the effects of any correction and thus be in a position to benefit from the post mid-term election surge.