Some Corrections Turn into Bear Markets

“A bull market is when you check your stocks every day to see how much money you’ve made. A bear market is when you don’t bother to look anymore.” – Bruce Kamich

In her excellent book “Bull”, journalist Maggie Mahar interviews Richard Russell on the three psychological stages of a bear market:

“The earliest stage is characterized by denial, increased anxiety, and fear. The second stage is panic. People suddenly say, ‘I’ve got to sell.’ The third phase is despair.” In the third phase, investors are so tired of the stock market that they don’t want to hear about stocks anymore, at any price”

Most corrections will remain just that – corrections. They won’t turn into bear markets. They will last a few weeks or few months. In the end, indexes will recover to new highs.

And yet, some corrections turn into bear markets. They are rare, but over 30-40 years of investing or trading, you will probably experience at least two or three of them – if market patterns continue to repeat. As long as there are humans involved, you can count on it. Markets always overshoot to the upside and the downside, because people’s psychology is cyclical and people tend to underreact to new information, then panic and overreact. Overreactions create the foundations for mean-reversions. Booms eventually lead to busts and busts to booms.

My definition of a bear market – spending a long time (more than a year) under a declining 200-day moving average, leading to 50% or bigger decline in a major, wide-encompassing index, like the S & P 500 for example.

You can imagine if an index is down 50%, what can happen to many individual stocks. No stock is insured against a bear market. Apple and Google lost 60% during the bear market in 2008. Amazon lost 95% during the bear market of 2000-2002. Priceline lost 99% in the same period. All of them managed to recover and hit new all-time highs afterward, but do you really think that you could have stomached the drawdowns that you had to go through? Do you really think that you could have put $1 million into PCLN and watch it turn into 10,000 and ride it all the way back without spooking at some stage and selling everything? Think again.

Are you familiar with the 50/30/20 concept? It states that 50% of a stock’s move is defined by the general market direction; 30% – by its industry; and only 20% is impacted by the individual merits of the underlying company. In a bear market, the 50/30/20 rule of thumb become something like the 90/10 rule, where 90% of a stock’s move is defined by the general direction of the market and only 10% – by the individual characteristics of that stock.

Traders should trade. Investors should invest. Whether you are a trader or an investor, if you deal with individual stocks, you always have to have an exit strategy. Some stocks never come back from their big drawdowns during market corrections.

This is a small excerpt from my book CRASH: How to Protect and Grow Capital during Corrections