correction vs. bear market

The financial media, in a deceptively over-precise way, has come to define a correction as a 10% fall in price of a given index during an ongoing bull market.  The same source defines a bear market as a fall of 20% or more.  There is some sense to making the distinction in this way, at least in that it’s unlikely that a market can fall by 20% and still be said to be retaining its fundamentally upward direction.  Other than that, I don’t find the 10%/20% distinction useful.

two worries:  price and earnings

To my mind, the key difference between the two–correction and bear market–is whether the favorable environment of expanding economies and resulting rising earnings per share which supports a bull market remains intact.

In a correction, stock prices have run ahead of the fundamentals and become too pricey.  We can no longer envision, say, achieving a 10% return from holding stocks for the coming 12 months.  Therefore, stocks have to fall to a level where buyers will anticipate a suitable return and reenter the market.  Buyers are concerned about price, not about earnings.

A bear market has very little to do with the 20% number.  What creates a bear market, simply put, is anticipation of recession, and the decline in corporate earnings that goes along with it.  Buyers don’t reenter the market after an initial fall, because they no longer believe that earnings will be rising.  They either continually withdraw funds from the  market or simply hold on to what they have and wait.  They look for some sign that the economic downturn the stock market has been forecasting has emerged—and reached its low point.  Historically, the turning point has been when the monetary authority begins to adopt a more accommodative stance.  Occasionally, it’s the legislature that acts.  Sometimes, it’s less action than investor perception that the assets of publicly traded companies are at bargain basement prices regardless of the near-term economic situation.

timeline

A correction runs its course in a matter of weeks;  a garden-variety bear market lasts nine to twelve months.

Where are we now?

For the mining industry–metals and oil–the picture has deteriorated dramatically over the past year.  This isn’t because the overall macro environment has weakened.  It’s because of overcapacity that the industry, in its typical shoot-yourself-in-the-foot fashion, has itself created.  This unfavorable situation will take a turn for the better only when substantial capacity is taken off the market.  Last time this happened for metals, in the early 1980s, the downturn lasted a decade.

Mining, and mining-dependent economies, apart, I don’t see any signs of actual GDP decline.  Yes, China may be growing at 5% instead of 7%.  Maybe it’s even 2%.  But it’s still growing.

So my vote is for correction.

One caveat:  as I’ve mentioned before, early September is the time when mutual funds in the US begin to sell to adjust the level of the yearend profit distribution they are required by law to make to shareholders.  Some of this selling may have been preempted by August’s market decline.  But until we see what the mutual fund situation is this year, I don’t think there’ll be much market desire to push prices higher.