How does an investor know if the market is in a correction or the start of a bear market? Many investors have a difficult time distinguishing the differences, and the psychological toll of watching the market drop day after day can lead to poor decision making.
The severity of sell-offs needs to be understood, especially in a trading environment where markets have experienced recent all-time highs and the economic, political and geopolitical risks seem to be front and center.
A pullback is a market drop of 5-10% and is very short term. It is a dip from a recent high during an ongoing bull market while upward momentum is still intact, and is a normal adjustment to a market cycle. The drops typically do not change the market sentiment or outlook. According to asset management and investment firm Guggenheim Investments, the S&P 500 Index has experienced 80 pullbacks since 1945 and had five separate 5% pullbacks in 2018 alone.
The market is in “correction phase” after a drop between 10-20% and can last a few months. These moves are typically met with higher volatility. Corrections can be violent as investors’ fear levels rise and panic selling may hit the market.
Real time news and social media can intensify this fear as investors may follow the herd mentality. The average market correction lasts anywhere between two and four months and is frequently accompanied by adverse market conditions. However, corrections are often seen as ideal times to buy high-value stocks at discounted prices. If the fundamentals of the overall market haven’t significantly changed, this may be true. If fundamentals have changed, however, buying may lead to significant losses. According to Guggenheim Investments, the S&P 500 Index has experienced 29 corrections since 1945.
A bear market occurs after a drop of 20+% over at least a two-month time frame. In a bear market, investor confidence has been shattered and many investors will sell their stocks for fear of further losses. Trading activity tends to decrease as do dividend yields.
Bear markets tend to become vicious cycles when rallies are sold and not bought. This happened in 2000 and 2007 and can typically be seen on charts as the market makes lower lows and lower highs. Bear markets tend to occur in the contraction phase of the business cycle and last, on average, approximately 16 months.
Bulls Follow Bears
Once a chart breaks above the downtrend and the lows start getting higher and the highs start getting higher, the bear market is over and the market has reversed itself back into a bull market. In the year after the three previous 20=% declines, the S&P 500 Index gained an average of 32%. According to Guggenheim Investments, the S&P 500 Index has experienced 11 bear markets since 1945.
Economic reports, geopolitical upheaval, weather and yes, global health risks, can bring about market downturns. But not all downturns are alike. They are defined by the size and duration of the decline, and it’s something all market watchers need to monitor.
Trader Georgi Bozhidarov