We’ve heard a lot about how the market touched bear market territory this month but is knowledge of any use for investors?

I must admit that I wanted to rant about all the punditry surrounding “correction territory” and “bear market territory” we’ve heard recently as the stock market closes out what was a rather sucky year. After several years of full-speed-ahead bull market action, 2018 started with confidence and ended with volatility.

But then I dove into the data and found something actually useful.

As stock prices fell, the media, fueled by Wall Street pundits, barraged us with all sorts of “terrible” warnings from Hindenburg Omens to Death Crosses. And now, with the Standard & Poor’s 500 down about 20% from its late September peak, the word is that the market “has entered bear market territory.”

Bear Markets Defined

Ask a TV journalist what defines a bear market and they will tell you it is a decline of 20% or more from a recent peak.

The problem is with that is it is totally an exercise in hindsight. It tells you nothing about what the market condition is now and where it might go from here.

Ask a market technician what defines a bear market and they will give you a more subjective answer. Mine is that a bear market is a major trend to the downside, no matter what percentage is already lost.

Is that helpful? Well, not yet.

Next, it is my responsibility to lay out what constitutes a “major trend to the downside.” Perhaps it is when the market crosses below its 200-day average. Or when the 200-day average itself is falling, as determined by, say, the 50-day rate of change. Or when the market makes its first set of lower highs and lower lows.

The latter is actually one definition of a falling trend. But are any of these enough to declare “bear market?” Or do we need even more qualifiers, including those averages, or perhaps a sell signal given by the bullish percent index? I’m intentionally not defining that indicator because that is not the point.

What is the point is that a bear market often begins at the high, or at the first short-term support break, or when we see a reversal pattern in a medium-term chart. After all, all big declines start with small declines.

We really just don’t know it’s a young bear market when it starts. And I really take issue with the declaration of a bear market after you’ve already lost 20% of your portfolio’s value. And then, do you sell what you have left to protect it or is the bear market over at that point making it time to buy?

Enter the Data

This brings me to the chart. I ran the S&P 500 back to the start of the secular bull market in the early 1980s on StockCharts.com with the zig-zag indicator overlaid on top. The zig-zag draws lines from the major highs and lows, changing direction only when the market moves by at least a predetermined percentage change. I used both a 10% correction and a 20% “bear market” to see what’s been going on.

(Click on image to enlarge)

My apologies for this packed chart but I needed to see when the market got its 10% and 20% moves. Also, the blue line, which is the 20% indicator, does not stop at 20%. It keeps going until the next major peak or trough that leads to a 20% move in the opposite direction. In other words, the line can be far greater than 20%.

Next, I drew in lines for every 20% decline – exactly 20% from the top of the previous rally that gained at least 20%. This shows us what happened when the market “entered bear market territory.”

What I expected was an upside reversal shortly after the 20% threshold in maybe two-thirds of the cases. What I found was that the market did, in fact, keep heading lower before finally rallying out of it.

Granted, the data only goes back to the early 1980s so I do not have a robust statistical potential here.

Conclusion

Based on this limited data set, I can see that during each of the two bear markets, there were two instances of at least 20% declines (only possible because there was a 20% rally in the middle of them). The market sliced through the first like the hot knife through butter. The second gave me my limited downside hypothesis.

That means – again with this very limited data set – that this decline is not over and the big 20% rally will lead to another leg down. How far? Beats me.

Will it happen that way? My view is that all of this was distorted thanks to the QE, ZIRP and TARP so it is likely to be distorted on the unwind. But then again, in 1987, there was only one 20%-plus decline (butter slicing, by the way) and no 20% rally leading to another decline. Maybe that’s what we’ll see in 2019.

It certainly would be a great colonic for the market.