Let’s Talk about Corrections and Bears

Here is what Investopedia says about corrections. “A correction is generally defined as a ten percent or greater decline in the price of a security from its most recent peak. A market may fall into a correction either briefly or for sustained periods of time, including days, weeks, months, or even longer.

“Market corrections occur relatively often. In February 2018, two major indexes, the Dow Jones Industrial Average (DJIA) and the S&P 500, both experienced corrections, dropping by more than 10 percent. Both the Nasdaq and the S&P 500 are also experiencing corrections this month.

On the other hand, a bear market is, “a condition in which securities prices fall and widespread pessimism causes the stock market’s downward spiral to be self-sustaining. Investors anticipate losses as pessimism and selling increases. Although figures vary, a downturn of 20 percent or more from a peak in multiple broad market indexes, such as the DJIA or S&P 500, over a two-month period is considered an entry into a bear market.”

Let’s take a look at where we are today October 28, 2018.

There are psychologically important thresholds that often presage shifts in market sentiment. The first cracks appeared earlier this month and laid the foundation for this week’s gyrations. And, despite Thursday’s rally, the technical signals predict more trouble ahead.

Certain prices, such as recent highs and lows and variations on the 50-day and 200-day moving averages, take on a symbolic importance to the market. Depending on market trends, those price levels can either establish a floor that supports falling prices or imposes a ceiling that resists a rally.

That’s why it was an ominous sign when prices Wednesday the S&P 500 E-mini futures were beaten below key support levels as easy as Mike Tyson taking on a punching bag. Now those levels are no longer a floor from which prices will naturally bounce higher, but have become an upper boundary that will make it harder for stocks to push higher.

It’s called a change in polarity when the old support becomes new resistance.

The thresholds may seem arbitrary to outsiders, but they aren’t just hocus-pocus. We’re not just jive talking here. Since most players in the market believe in their significance, they end up having real-world heft.

For example, traders use them as stop-loss signals, which is why selling often accelerates after an important technical level is breached. That’s what happened two weeks ago, and again on Wednesday.

People are selling first and looking to ask questions later

However, an analysis surveying the past 65 years of the S&P 500 finds that sharp initial drops are hallmarks of run-of-the-mill corrections, defined by declines of between 10% and 20% in equity prices.

On average, recovery follows within six months, and a rally within a year.

By contrast, bear markets typically start with deceptively gentle drops.

From its last peak on September 20^th until the market close on Thursday—35 days—the S&P 500 fell 7.8%. Judging by history, this looks like a correction. These corrections have started with a median 6% fall over the same length of time, compared with 4% for bear markets.

In fact, following the 10 largest 35-day selloffs, stocks ended up bouncing back in nine cases. Only one eventually turned into a more-sinister bear market. The current rout falls in seventh place, whereas the 2007 selloff that heralded the global financial crisis—and a 36% stock-market loss within a year—doesn’t even enter the ranking; it started with a 5% fall.

A likely explanation is that markets don’t become smarter overnight. Useful information that hints at the end of the economic cycle drips in over time. Sudden changes of heart on how to interpret the available data are more often just irrational.

If history is any guide, the bear market, when it finally comes, will arrive with a whimper, not a roar