Some Perspective on This Rocky October

After another bout of sharp negativity, global markets pierced correction territory Wednesday, closing down -10.2% from their January 26 high.^[i] US stocks had a particularly rough day, with the S&P 500 dropping -3.1%.^[ii] Amid coverage searching for causes and speculating about what may come next, we saw many headlines featuring the scary term, “bear market”—not merely to warn one may be in the offing, but to argue this or that group of stocks is already in one. Some concluded a “rolling bear market” must be underway. In our view, this fundamentally misunderstands what a bear market is—and most evidence indicates we aren’t in one today. Although the recent dip has understandably made many nervous, we think knowing the difference between short-term market wobbles and a bear market might help soothe worries. 

In brief, here is that difference: A bear market is a prolonged, fundamentally driven, broad market decline of -20% or greater—while a correction is a short, sharp, sentiment-driven drop exceeding -10%. The difference in cause is critical. Bear markets have fundamental drivers we believe it is possible to identify as (or soon after) they materialize. Conversely, corrections are functions of mass sentiment or psychology. As such, it may make sense to reduce stock exposure if you see a major negative surprise others miss and believe a bear market is underway. But we believe reacting to corrections—however tempting when fear swells—can wreak havoc on long-term returns.

As we have written and still believe, the current pullback appears to be a correction—not a bear. (More on this below.) But casual financial news consumers could be pardoned for thinking a bear market is already underway—or even several of them at once! Scan headlines, and you may see mentions of “bear markets” in select Industrials stocks,^[iii] European Tech stocks,^[iv] cannabis stocks,^[v] Chinese stocks,^[vi] Emerging Market stocks,^[vii] European auto stocks,^[viii] European Financials stocks^[ix] and exactly 179 S&P 500 stocks.^[x] This sounds like a lot—and it is arguably accurate in a technical sense, since each has neared or breached the -20% marker. But we think characterizing -20% or greater declines in such-and-such a sector or category of stocks as bear markets is off base.

In our view, the term “bear market” is generally meaningful only if it applies to broad, market-cap weighted market indexes covering a large chunk of the world. The reason: -20% drops in narrow stock categories, much less individual securities, are common and don’t automatically coincide with actual broad bear markets. Having some stocks up a lot and some down a lot isn’t a weird anomaly—it is par for the course in broad market indexes containing many different stocks with varying outlooks and drivers. Diversified investors might not notice most of the time, as high/low extremes partially or entirely offset each other. But a correction tends to heighten folks’ focus on negative minutiae.

Even entire countries can fall into bear markets without automatically imperiling globally diversified investors. Consider China, where mainland stocks are in the midst of their fifth bear market in the last 10 years. Some coincided with global corrections, but none with a global bear—or even a Chinese recession, for that matter. It is also normal for smaller, less diversified countries to fall more than -20% during a global correction. This is why magnitude alone doesn’t determine a bear—breadth is necessary, too. The same holds for sectors or industry groups, which may respond differently to fundamental drivers. Falling oil prices, for example, may be bad for Energy firms. But they can benefit Chemicals producers.

A certain percentage of stocks in an index entering “bear market territory” isn’t a meaningful data point, either. In market-cap weighted indexes,^[xi] the largest companies hold the most sway. Treating a -20% drop in a small-cap and a mega-cap stock as equally bad—which simply counting up “bear market” stocks does—is a fallacy. The proportion of an index’s stocks in mini-bear markets may be interesting trivia, but it isn’t how investors experience returns and should have no bearing on your decision-making if you have a diversified portfolio positioned to target long-term growth.

Lastly, there is no such thing as a “rolling bear market,” where declines in one category “spill over” or “infect” others. This is just a fancy way to argue past prices drive future returns. They don’t: Markets don’t have “momentum,” and different sectors and stocks price in public information at the same time. The notion of a gradually spreading “contagion” infecting one group of stocks after another is a myth. It isn’t as if Consumer Discretionary stocks will soon discover the dangers Industrials stocks already knew.

To be clear, it is possible a global bear market has begun—just as it is possible any decline could be the start of a bear. But investing is about probabilities, not possibilities—and a bear market remains improbable, in our view. The far more likely explanation is a rekindling of early 2018’s correction. Despite the dour sentiment presently punishing stocks, we think fundamental drivers point to more bull market ahead. Major economies are growing and forward-looking indicators like leading economic indexes and businesses’ new orders point positively. Gridlock grips legislatures throughout the developed world, likely preventing the sort of radical legislation stocks dislike. Next month’s midterms likely increase gridlock in the US. These are all underappreciated positives we believe markets will later price in.

Popular mooted causes of present volatility—like Fed rate hikes, slowing earnings and Tech weakness—are widely discussed (sapping surprise power) and long-running. Bear markets generally stem from huge, unseen negatives erasing trillions from global GDP. Moreover, with pessimism abounding, the bar is lower for reality to clear—a powerful bullish force. Hence, we believe stocks should rebound from the present correction as present fears prove overwrought. It is impossible to know when this happens—predicting volatility’s end is as feckless as predicting its onset—but we think investors are best off waiting for it to do so. In the meantime, we advise taking headlines citing “bear markets” in this or that corner of the market with some grains of salt.