Corrections, Bear Markets, Recessions and Crashes
Volatility comes in waves.
Bloomberg, January 22, 2016
The recent financial market volatility has many people wondering if this stock-market decline will turn into a bear market. Others are wondering if a recession is imminent. Still others wonder if a full-blown market crash or a financial crisis like 2008 is in the offing.
I don’t claim to have the answer to those questions. However, I do have data that can help put this into context. You are on your own, however, in determining what this means about your own portfolio or trading needs.
Let’s start with the simple truism that while every deep sell-off first has to pass the 10 percent correction mark, not every 10 percent correction becomes a deep sell-off. I know I have trotted out these statistics so often that you’re bored of them, but once more for the newbies: Since 1950, the Standard & Poor’s 500 Index has experienced a decline of 10 percent or more once every two years on average. Note that the distribution doesn’t fit some nice, clean pattern and it isn’t just even or odd years. Like waves, there is a tendency for declines to come in sets. Think of it as periods of greater or lesser volatility.
I would be remiss if I failed to acknowledge both the rapidity of the current decline and its inauspicious beginning at the start of the new year. That makes it emotionally feel much more significant than a standard 10 percent correction. (But we know how misleading those emotions can be).
Why is 10 percent classified as a correction? It’s the first double-digit number in our counting system, but it is also how many fingers you are supposed to have. Either explanation suffices, with “Why not?” just as good an answer as any.
About those bear markets: Since 1928, we have seen at least 23 sell-offs of 20 percent or more, which is the official definition of a bear market. Again, why 20 percent? There is no better explanation than that it’s the total count of digits — fingers and toes — most of us have. It is also double the magnitude of a correction. Let’s simply agree these numbers are completely arbitrary, and move on to more relevant data.
Those 23 bear markets over a span of 85 years work out to one about every 3 ½ years or so. As the chart below shows, their appearances as indicated by the gray bars are not a smooth Gaussian distribution. Look at 1946 to 1958 or 1988 to 1998 — we sometimes go a decade or so without a bear market. My colleague Michael Batnick also observed that “drawdowns of 20% or more have happened 26% of all years. On five of those 23 occasions, stocks still ended up positive on the year. . . It’s not unusual for those double digit declines to be of little importance. 57% of the years with 10% drawdowns finished positive.”
Source: Ritholtz Wealth Management
Last, about the recession question: I can do no better than point you to Paul Samuelson, perhaps the most influential economist of the latter half of the 20th century. His quip that “Wall Street indexes predicted nine out of the last five recessions” may have been said in jest, but it is also turns out to be true.
For a deeper dive into the subject, let me point you to research by my colleague Ben Carlson, who earlier this week discussed times when stock markets fell but a recession didn’t follow. He observed that there have been 16 corrections since World War II that didn’t lead to a recession. On average, markets fell 19.4 percent during those episodes.
Thus, I leave you with this observation: We don’t know if this correction will be modest or significant, a full-blown bear market or worse. Lacking sufficient information to make an informed decision, I only suggest you don’t make wild unsubstantiated guesses with your portfolios.
Originally published here: Corrections, Bear Markets, Recessions and Crashes