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 


10 Musings about Market Corrections

  1. Deep corrections last long enough to condition people to sell their winners quickly because of frequent reversals in direction.
  2.  Some say that If you don’t have a plan, you will become part of someone else’s plan. Well, the problem during corrections is that many are not able to follow their plan – not because they don’t want to, but because the market doesn’t let them. Hint – the gaps above and below your stops. The cure is to decrease our position size and the frequency of our trading.
  3. Market corrections come slower than most expect, but once they arrive – they escalate faster than most can imagine. Peter Lynch’s words are a good reminder here – “far more money has been lost while preparing for corrections than during the corrections themselves”. Keep in mind that most of Lynch’s career as a mutual fund manager took place during a secular bull market.
  4. The market is not going to be healthy all the time. 8% to 20% correction happen at least once a year every year. Steep corrections create incredible opportunities, but you have to protect your capital in order to take advantage of the recovery.
  5. Once in awhile, a correction will turn into a bear market. They say that both bulls and bears lose money during bear markets – bulls, because they stubbornly hold to favorite story stocks while they are crashing and then they give up near the bottom; bears – because they get squeezed by frequent face-ripping rallies under declining 200-day moving averages.
  6. All corrections feel the same. In the beginning, people don’t believe them, then as prices continue lower and weakness spreads to more sectors, fear escalates and it leads to forced liquidation. Forced liquidation means selling, because you have to, not because you want to. Smart investors dream to be on the other side of forced liquidation.
  7. At the lowest point of a correction, the fear of losing is substantially higher than the fear of missing out.
  8. During corrections, correlations often go to 1.00, which means that stocks move together up and down disregarding of individual merits. If a stock manages to hold its ground and consolidates through time or even make an attempt to make a new high, it is likely being accumulated by institutions. Because of the nature of their size, many institutions prefer to buy on pullbacks and during market corrections. Selloffs provide liquidity that masks their accumulation. Once the pressure from the general market is removed, those stocks tend to outperform.
  9. Bottoms are made by heavy buying, not heavy selling. Stocks not going down on what appears to be bad news is a positive sign.
  10. “It is not entirely clear what causes deep market corrections, but without them, many of the best performing long-term investors would have never achieved their spectacular returns.” – Peter Lynch