Our Perspective on the Nascent Rebound

After another positive week, US and global stocks have pared about half of their peak-to-trough declines during this correction, give or take. Or, what we think is a correction—a sharp, sentiment-fueled drop of -10% to -20%. Some have a different opinion and warn the past few days could be a mere sucker’s rally—a temporary positive burst that fools people into buying during a bear market, which is typically a much longer, deeper decline of -20% or worse with a fundamental cause. In all fairness, this is possible. Yet investing isn’t about possibilities—in our view, it is about probabilities. To avoid getting faked out, we think it is helpful to bear in mind some of bear markets’ typical traits.

Corrections are usually short and steep from start to finish. They tend to start and end without warning, and they fall on feelings—sometimes tied to a big story, sometimes for no apparent reason. Sentiment usually deteriorates throughout, generating a barrage of this time is different arguments that the decline will get worse. But then they end, usually as suddenly as they began, and a steep recovery typically follows. In our view, the best thing for someone seeking long-term growth to do during corrections is grit their teeth and hang on, lest they sell after a decline and miss the rebound—and miss returns that could compound over time.

Bear markets, by contrast, tend to last several months or more, usually rolling over gradually, with the worst declines coming late. In 2020, this wasn’t the case, as the bear market lasted just five weeks for the S&P 500 and six for the MSCI World Index—as we have written, it was more like a correction than a bear market, despite the fact it technically was a bear market (the magnitude exceeded -20% and, in the lockdowns, it had a fundamental cause). But that instance aside, bear markets are usually long grinds, and we think their slow start is what makes it possible to carve out a chunk of them.

In general, bear markets typically behave similarly. Their monthly decline usually averages around -2%, give or take—sometimes a bit more, sometimes a bit less. Additionally, two-thirds of their decline by magnitude tends to come during the final one-third lifespan. Therefore, we think it is wise not to consider exiting stocks until you are at least three months from the most recent peak. That gives you a good window to assess the decline’s pace as well as the fundamental backdrop. If it is a steep drop, then you are probably in a correction. If it is gentle and the financial news world is full of articles preaching buy the dips, there is a higher likelihood you are in a bear market.

As we write, stocks are less than three months on from the most recent peak. This is helpful because it means you don’t need to make a snap decision about the past week’s rally. If it is indeed the rebound from the correction, that will become apparent soon enough. If it is a bear market rally, eventually it and the surrounding declines will likely even out into that roughly -2% or so monthly decline. Said differently, the rally will become part of that slow rolling top. Patience is difficult at times like this, but we think it is vital to seeing things clearly and reducing the risk of a portfolio error.

The three-month window isn’t just for watching market movement—it is also for assessing fundamental conditions and sentiment to determine realistic probabilities about what likely lies ahead. As we write, based on our ongoing research and analysis, we think this is quite likely a correction, not a bear market. Maybe we are already in the recovery, or maybe this is a correction with a W-shaped trough instead of a V. But we don’t see the general conditions that usually bring a bear market.

When analyzing the long arc of market history, we find bear markets usually begin one of two ways, which we call “the wall” and “the wallop.” The wall happens when stocks finish climbing the bull market’s proverbial “wall of worry,” and euphoric sentiment gets far ahead of reality. The euphoria itself isn’t bearish, but it blinds investors to approaching risks and deteriorating fundamentals, eventually driving stocks lower. The dot-com crash and bear market in 2000 – 2002 is a classic example. The wallop, as the name suggests, is a huge, shocking negative with the power and high probability of deleting several trillion dollars from global GDP, which is what it takes to cause a global recession. Early 2020’s global lockdowns were a wallop, as was the US mark-to-market accounting rule’s impact on bank balance sheets in 2007 – 2009.

When stocks started declining early this year, investors weren’t euphoric—far from it. Sentiment had deteriorated throughout 2021, resulting in a messy mix of skepticism and optimism when this year began. Inflation, geopolitics and pending Fed rate hikes were all sending investors’ expectations lower. As for a wallop, we have addressed all three in detail in recent months and, in short, we don’t think they qualify. We aren’t saying they are good, but at this juncture, we don’t think they have the size or surprise power necessary to send stocks far lower for far longer. Rather, all three are classic correction stories, much like China’s “devaluation” in 2015 and the eurozone’s debt crisis in 2011 and 2012.

The “sucker’s rally” warnings we are seeing now are also quite typical of a correction—they are emblematic of the fearful sentiment that reigns. Early bear markets, by contrast, aren’t that fearful. The early declines seem so gentle that few extrapolate them. They more often dismiss the declines, prompting the aforementioned chorus of buy the dips chatter. If bull markets climb a wall of worry, then bear markets roll down a slope of hope.

One of the most frustrating things about stocks is that inflection points are clear only in hindsight. But investing has always been an endeavor of probabilities, not certainty—and not possibilities. In our view, while we can’t (ever) be certain, the overwhelming probability today is that this year’s early volatility is (perhaps was) a correction, with still-brighter days likely to come sooner than many think.