Corrections, Bear mar­kets, re­ces­sions and crashes

The Pak Banker - - OPINION - Barry Ritholtz

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 sell­off first has to pass the 10 per­cent cor­rec­tion mark, not ev­ery 10 per­cent cor­rec­tion be­comes a deep sell­off. 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 sell­offs 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." 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.

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