The Boy Who Cried Wolf

A shepherd-boy, who watched a flock of sheep near a village, brought out the villagers three or four times by crying out, “Wolf! Wolf!” and when his neighbors came to help him, laughed at them for their pains.

The stock market reminds me a little of this classic story. Human psychology fascinates me. For all the market’s ups, downs, twists and turns, you would think that investors would have become accustom to the stock market’s cry for wolf. Alas, human beings are not wired to do so.

It wasn’t too long ago that the Aussie stock market was down 10%, and global stock markets down around 20%. The Aussie stock market has recently made a high we haven’t seen since pre GFC.

To celebrate the recent milestone, let’s take a look at what is considered a pullback, a correction, and a bear market. These terms that I am using are basically financial jargon – made up by pundits. Generally speaking, a pullback is a decline of 5%, a correction implies a decline of 10%, and a bear market is a decline of 20%. Now that I have impressed you with my financial terminology, let us continue.

Pullbacks

These happen a couple of times a year – most people don’t even realise.

Corrections

On average, the stock market sees one correction per year. The average length of a correction is 71.6 days. On average stocks decline about 15.60%. Once the decline hits it’s bottom, the market typically takes about 4 months to get back to where it was.

Ben Carlson found that when stocks cross the 10% decline threshold, almost half of the time they don’t fall more than 15%. About 60% of the time, according to Carlson, a decline of 10% doesn’t foreshadow a bear market; 40% of the time it does. Perhaps this explains nervousness among investors about a moderate and normal 10% decline. Since we tend to fear losses more than we like gains, this might account for the anxiety — the expectation that worse is to come.

In fact, between 1980 and 2018, the US stock market has declined about 10% 36 times and 5 of those corrections resulted in longer bear markets. The other 31 transitioned relatively quickly back into bull markets. In other words, in recent history, about 14% of corrections were the start of a prolonged downturn – but most are just blips on the radar.

Bear Market

Now this is something different. Investors find a new level of craziness at this point – perhaps residual post traumatic stress from the GFC. Markets have always recovered from what has been proven to be a temporary bear market – although it never feels like it during the time. We’ve all experienced a bear market in varying degrees. From 1973 where the stock market fell about 57%, to the dot-com bubble where the stock market fell about 88%, to the GFC where the stock market also fell about 57%.

The world economy will continue to rise and fall. Investors will continue to anticipate and respond to global events. I will leave you with the below chart (click for larger image) which illustrates the performance of the US stock market since 1896. It shows the market’s peaks and troughs, a reflection of the US economy’s triumphs and tribulations.

At its simplest, the chart proves once again that over the long term, the stock market always rises because intelligence, creativity, and innovation always trump fear. Yet at the same time, it also underscores the basic mantra that market participants need to stay nimble during times of uncertainty to maximize their returns.