The stock market (as measured by the S&P 500 index) is down sharply since the start of the year. We thought we would use this moment to clarify some of the terminology and nuances of market downturns.
Amid a long and substantial increase in the stock market (a “bull market”), there are always zigs and zags. The long-term bias of the stock market is up, as economic growth and corporate profits rise more than they fall over time. There also is a deeply held cultural belief in the stock market that is supported by the media, investment firms (that need funds from investors to make money), and by tax policy.
There are times, however, when the market declines more significantly than its normal zags. A decline of more than 10% is labelled a “correction” in a bull market.
In fact, a “correction” is often called a “healthy correction” in a bull market that has become overly exuberant. The assumption is that a correction is a good buying opportunity because stocks always go up, don’t they? At least that’s what investors—especially individuals—think in the late stages of a bull market.
But what happens when a correction doesn’t bounce back and the decline continues? At what point is it no longer “healthy”? Ah, there’s a term for that, too: a “bear market,” when the decline exceeds 20% from the market high.
But what is an investor to do then? It’s true that few bear markets end with a decline of “only” 20%. Perhaps it’s best to step aside for a while then and avoid further losses in a possible crash or even a depression. But how does one know how much a bear market decline will be? There’s the rub. History, however, does provide some help.
There have been eight bear markets since 1960 (excluding the unique plunge in February 2020 at the start of the pandemic). The median decline in the S&P 500 was 34%, with an average duration of 18 months. There have been three epic bear markets, with an average decline of 51% over 23 months.
We think it’s a waste of time to engage in speculating why the stock market does what it does. Simply put, it comes down to supply and demand. While there is always a buyer for each seller, when the intensity to buy is greater than the intensity to sell, there is pressure for prices to rise—and vice versa when the intensity to sell is greater than the intensity to buy. Plausible reasons after the fact don’t matter.
Instead of waiting for a drop of 20% in the stock market to consider whether to reduce exposure, we think it makes sense to do so on a gradual basis as the balance of attractive opportunities versus the risk of loss becomes increasingly unfavorable. Whether that occurs when stocks are still rising or whether there has been a “correction” or, especially, a “bear market” doesn’t matter.