Correction or bear market?
BY MICHAEL KAHN, BARRON’S — 06/09/10
How to tell the difference between a buying opportunity and a time to move to cash.
There are as many opinions about the stock market’s action in May as there are analysts. Was the rally from the March 2009 low a secular bull market or a cyclical bull within a long-term bear market? In either case, was the decline in May a correction or the start of something worse?
You won’t get a definitive label from me here. But this week’s comeback does not change my view that stock prices have unfinished business to the downside that can last well into the summer, if not beyond.
What is a name in the market anyway? To loosely paraphrase Shakespeare, a bear market by any other name will not smell so sweet. Getting boxed into a point of view by the label one assigns to the market is never a good idea. That is why I am not keen to use the term “bear market” right now.
There is an old joke on Wall Street, again paraphrased, that a correction is when you lose money and a bear market is when I lose money. It means that labels of bull and bear are most often dependent on one’s investment time frame and aggressiveness.
The real question for investors is what to do about it, not how to label it. Clearly, the earlier we can make the distinction between a market “on sale” and one that has changed its trend, the better our results will be.
Relying on the standard that a 10% decline is a correction and a 20% decline is a bear market is the same as driving a car using the rearview mirror. Once stocks are down by 20%, there is a good chance that your portfolio is also down by close to that, and even long-term investors do not use stop-loss orders on that scale.
Finally deciding to sell stocks only after an arbitrary line is crossed is a major reason why many investors sell at the bottom.
Using percentage decline standards are great for analysis of the past. They are not very good for deciding what to do in the here and now.
One method I like is taking a step back from the day-to-day wiggles and looking at the long-term condition of the major indexes. Talk in some technical analyst circles recently has turned to the Standard & Poor’s 500 being in the midst of a giant topping pattern familiar to even casual users of charts — the head and shoulders.
In simple terms, this pattern includes several bits of technical evidence for a change in trend, including the break of the trendline supporting the bull market and a failure to set a higher high and higher low. The reversal is complete when the market moves under the lows set within the pattern, also known as a breaking support. At that time, the odds shoot higher that much lower prices are coming.
For the S&P 500, the January high is the left shoulder near 1,150 and the April high of 1,217 is the top of the head. The lower border is at 1,050, in round numbers, and corresponds to the lows of February and June to date.
To be sure, waiting for the market to close below 1,050 means that it will already be down 14% from its high. But that is not an arbitrary distinction between correction and bear market. In this case, it is the market that dictated the percentage decline, not an analyst or journalist. The distinction is critical.
Chart watchers are now debating how the right shoulder of the pattern will develop. In a perfect world, the right shoulder should move to the same levels as the left shoulder, meaning a rally for the S&P 500 to 1,150. Coincidently, that is where the widely watched 50-day moving average is today. Should the market fail there, the argument for another trip down to 1,050 becomes strong.
However, should the market fail to keep this week’s bounce going — and Friday’s retail sales report could be the spark — then the argument for a swift decline and a continuing bear market becomes compelling.
If and when that happens, the labels of correction or bear market will not matter.
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