Check These 2 Signals Before Trying To Time A Market Correction

By: Brendan Erne, CFA

What is a market correction? A widely accepted definition is a drop of 10% or more in the stock market.

This isn't necessarily a bad thing. As the name would imply, the market “corrects” itself to a more fundamentally sound trajectory.

Still, it'd be nice to watch this correction from the sidelines. It'd be even nicer not to exit a moment too soon. So how do you tell when its time to cash out?

The first signal to check is the price-to-earnings ratio, or the “PE." Many investors look to see if equity valuations are ‘overstretched.' Right now, the S&P 500 is trading at around 16x forward earnings, which is approximately in line with its historical average.

But don't panic because the price-to-earnings ratio isn't a clear indicator right now. Just give up. Attempting to time corrections is dangerous. Take last year for example. At the time, many said a correction was overdue, just as today. But if you ditched stocks in favor of cash or bonds, you would have missed the S&P 500's +32% return. Even if you time the downturn perfectly, you still need to know when to jump back in.

What's the second signal to check? It's not a market signal. It's whether you have a diversified portfolio. Diversification at the asset-class level (equities and bonds) is obvious. But there's another layer of diversification not all of us consider: within equities. Most people think their index funds do the full job of diversification – exposing them to the broad market.

Index funds can contain sector skews, though, especially after a bull market. The S&P 500, for instance, is market capitalization weighted. So during a market run up, its allocation to sectors that are performing well, such as Technology, continues to rise and rise.

Since many of us hold index funds like the S&P 500, our portfolios might have big sector bets – bets that we didn't intend to take. Higher exposure to “momentum” categories can happen without us even realizing. And since these skews occur within each individual fund, they're hard to monitor.

Personal Capital's award-winning app can help you find any sector skews currently hiding in your index funds – within minutes. You can view all your accounts, all in one place. And see how you stack up against an optimal allocation.

If you work with our advisors, Personal Capital's Smart Indexing investing could also help ensure you aren't overly exposed to “momentum” sectors. Smart Indexing strategies more equally weight sectors, size, and style - creating an additional layer of diversification.

Over time, Smart Indexing could reduce volatility and improve portfolio returns.