Humans are hard-wired to hate losses, and all market declines-no matter the cause-result in smaller numbers, red font and down arrows when you log into your brokerage account or open your statement, as the case may be. The red is hard to avoid when you tune into CNBC. Hence, it is understandable that, on the heels of sharply negative markets from mid-2015 to early 2016, some folks' nerves remain a bit frayed. Negative markets are an unavoidable part of investing-in stocks, bonds, and pretty much anything other than cash. A key step toward dealing with negativity is having rational expectations. And, to that end, it's crucial to understand not all market negativity is the same. Knowing the differences can help you interpret financial media and keep an even keel whenever negativity strikes next. Preparing now for that eventuality helps make you a savvier investor.
An important first step is understanding the language of market negativity. Not every firm or media outlet, let alone every pundit, uses the same terminology. To be clear, we are not discussing volatility. Volatility may be negative, but it can also be positive. A 2% daily rise is equally as volatile as a -2% drop. It is directionless. Negativity, obviously, isn't.
The two most commonly used terms to discuss periods of market negativity are bear markets and corrections. Less common, but still worth discussing, is the term drawdown. We'll cover all three of these terms and include some real-world examples.
What Is a Bear Market? What Causes Bear Markets?
A bear market is a lengthy, fundamentally driven decline, generally exceeding -20%. The key to that sentence, though, is not the return figure. It is the cause that differentiates it from corrections-the phrase fundamentally driven. This implies the downturn is a rational market move. In a bear market, stocks are pricing in the negative fundamentals-for example, a coming recession, a damaging regulatory shift or other-causing the downside.
Usually, in a bear market's early stages, these negative fundamentals are unnoticed, dismissed or ignored by most investors, due to widespread complacency or euphoria. 2000's "profits don't matter, only clicks" tech-bubble hype obscured a slew of negative signs, including inflated valuations for firms burning through cash, a flood of new stock supply via IPOs and an inverted yield curve-(short-term rates exceeding long-term rates). Less often, negative fundamentals stem from an external factor that crushes earnings/profits/economic growth-a wallop. 1937 is a good example, when the Fed massively jacked up reserve requirements, encouraging banks to slash lending and attempt to raise more capital suddenly. 2008 is another, as a new accounting rule implemented in late 2007 forced banks to unnecessarily write down trillions worth of viable assets that temporarily lacked a market, even though they didn't plan to sell them.[i]
While no one-including us-has a perfect record of doing so, we believe it is possible to identify bear markets before they wreak all their havoc, since they have fundamental, identifiable causes. If you can foresee a bear market early enough, getting out of stocks to avoid downside may make sense. Nailing the exact top and bottom isn't likely at all, but it is possible to cut out a swath of the decline. Importantly, it isn't necessary to forecast bears to get good returns in stocks-their roughly 10% long-term return includes bear markets-but it can help, if done successfully. The opportunities will be limited-there have been only four bear markets in the last 30 years (2008-2009, 2000-2002, 1990 and 1987).
At their outset, bear markets usually aren't identified by many investors. They tend to start gradually, with most of the negativity towards the end. By then, stock market declines are usually steep enough that few are unaware. Mass sentiment shifts from dismissing negative fundamentals to exaggerating them. It's this exaggeration of negativity that causes bear markets to end-a reality less bad than the worst case scenario commonly envisioned is fuel for stocks to rise.
What Are Stock Market Corrections?
Corrections are far more common. We define corrections as short, sharp, sentiment-driven down moves exceeding -10%. This is a common definition in the industry, but not the only one. Some folks use the term to mean any downside. Others suggest it is any non-bear market decline. Those are too liberal, in our view. The key here, again, isn't the magnitude. It's the term sentiment-driven. Corrections are not fundamentally supported-they are irrational down moves amid a broader uptrend (a bull market). It may sometimes appear they are fundamentally supported-like in 1998's big correction-but the fundamental reach isn't broad or deep enough. (Then, it was regional economic weakness mostly isolated to Asia.) Corrections are features of healthy bull markets, keeping sentiment from getting overly positive. When they hit, headlines usually notice and connect them to some broader cause-real or just perceived. When they end and stocks rise, headlines are usually in disbelief, as the factors they pointed to aren't fixed. 2016 is a case-in-point.
Greece in 2010 is another perfect example, when fears over a Greek national default contributed to a sharp correction that began in April and ended in July. At their worst, global stocks fell 16.0%.[ii] Headlines were apocalyptic. Greece, we were told, could drive a double-dip recession. Greece was Lehman Brothers on a bigger scale. But, fundamentally, Greece was never the threat people presumed. It had major problems, to be sure. But those problems were insufficient to render a global bear market. When the year ended, stocks were up double digits. Greece wasn't suddenly fixed, growing and creditworthy, as data in the subsequent years would show. Quite the contrary. Its issues were real enough, but fear greatly and irrationally inflated them. The global market downturn was caused by sentiment. Sentiment shifted and stocks moved past Greece. By contrast, while we figure it is possible, we aren't aware of any historical bear market caused exclusively by sentiment.
Given the lack of fundamental cause behind the correction, there really wasn't a way to foresee when it would start or end. Heck, news of Greece's budget issues first broke over four months before the correction began. Their issues remain to this day. Corrections are random, based on the whims of investor sentiment. We don't know of anyone with a history of repeatedly forecasting corrections. If you could, then getting out and buying back in at the low would be great. But corrections move so fast and unpredictably, there is a much greater chance you don't time the move well. By the time you are technically in a correction, chances are good the downside is nearly over. It is also incredibly unnecessary to time corrections. The aforementioned 2010 Greece-related correction is one of six bull market corrections we've seen since March 9, 2009. Over that full period, stocks are up significantly.
Of course, there is never 100% certainty what you think is a correction isn't a bear. Portfolio management is about probabilities, not certainties. But if you broadly assess fundamentals and they aren't negative, history suggests the chances are very high you're looking at a correction.
Another, more obscure, term industry types use to describe negativity is a drawdown. A drawdown is any peak-to-trough decline during a given period of time. No cause. No size range. It is a looser term, often used more liberally. One common way is to take a span of time, say a year, and find the biggest decline that occurred at any point that year. That is the year's maximum drawdown. We often find this misused, like in this article, which argued an initial Fed rate hike is bad for stocks. The article claims there was a drawdown exceeding 5% in the six months before or after an initial Fed hike in 13 of 16 historical tightening cycles (this was written before the December 2015 hike).[iii] The trouble, of course, is that if stocks initially followed the hike by rising and fell later in the period measured, you likely have a false read. And, six months before the hike stocks could be moving on factors unrelated to the Fed.
Now, of course, there is still the issue of day-to-day drops, and the media often hypes things like "triple-digit Dow declines." (We have often written the Dow is a broken index, but we have yet to convince the media it isn't worth reporting.) Based on a Dow level of 18,448 (where it closed August 25), a 100-point drop equals -0.54%. Tiny! Besides, daily movements aren't worth fretting.
The media also uses the term "crisis" quite liberally. But it stretches credulity when the same term is applied to a huge recession and bear market like 2008's Global Financial Crisis and the Fiscal Cliff Crisis, which had a market impact that rounds to zero. We'd advise them to differentiate, but we doubt they'd listen.
Ultimately, if you need to earn equity-like returns on some or all of your portfolio to fund your needs or goals, you will have to accept the negativity that sometimes comes with the territory. It's uncomfortable, we know. But there is no smooth upward ride to high returns. However, preparing yourself mentally for negativity is a key trait of savvier investors.
[i] Many see this as a case of the former, citing the housing bubble, but that isn't quite right in our view. Home prices began declining in 2006, not 2007 or 2008. Further, actual loan losses were dwarfed by the aforementioned, FAS 157 motivated writedowns.
[ii] Source: FactSet, as of 5/6/2016. MSCI World Index return with net dividends, 4/15/2010 - 7/2/2010.
[iii] This count is also incorrect, but that is an article for another day.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.