Confusing Market Crashes & Bear Markets

Over the long term, confusing market crashes and bear markets can be detrimental to investor outcomes. Yet, this is what Morningstar did recently in discussing the market correction in 2020. To wit:

“The market downturn caused by the COVID-19 pandemic was one of the most severe in recent history, but it also proved to be one of the fastest recoveries. This episode reinforces two important lessons for long-term investors:

  1. Don’t panic and sell stocks when the market crashes.
  2. It’s very hard to predict how long the stock market recovery will take.”

Confusing Market Crashes Bear, #MacroView: Confusing Market Crashes & Bear Markets. (Part-1)

During the downturn, I made these points in an article about the history of market crashes. I showed that the 150-year record of U.S. market returns is littered with bear markets (downturns of 20% or more)—and in each case, the market eventually recovered and then went on to new heights.”

 

Not A Bear Market

The problem with the analysis is that March was a “correction” and not a “bear market.”

Let me start with an insightful note from Sentiment Trader:

Using the completely arbitrary definition of a 20% decline from a multi-year high, it has taken the index only 110 days to cycle to a fresh high. That’s several months faster than the other fastest recoveries in 1967 and 1982.”

Such was a point I discussed on May 20th in “Just A Big Correction:”

“Price is nothing more than a reflection of the ‘psychology’ of market participants. A potential mistake in evaluating ‘bull’ or ‘bear’ markets is using a ‘20% advance or decline’ to distinguish between them.”

Importantly, the 20% rule is completely arbitrary.

The question is, after a decade-long bull market, which stretched prices to extremes above long-term trends, is the measure still valid?

To answer that question, let’s clarify the premise.

  • A bull market is when the price of the market is trending higher over a long-term period.
  • A bear market is when the previous advance breaks, and prices begin to trend lower.

The chart below provides a visual of the distinction. When you look at price “trends,” the difference becomes both apparent and useful.

Confusing Market Crashes Bear, #MacroView: Confusing Market Crashes & Bear Markets. (Part-1)

The distinction is essential.

  • “Corrections” generally occur over short time frames, do not break the prevailing trend in prices, and are quickly resolved by markets reversing to new highs.
  • “Bear Markets” tend to be long-term affairs where prices grind sideways or lower over several months as valuations are reverted.
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