September 2, 2007
Fundamentally
Count the Days, Not the Years, of Market Pullbacks
By PAUL J. LIM
THE big fear on Wall Street is that the growing mess in the mortgage market may trip up the second-longest uninterrupted bull market in history, after the run-up from 1990 to 1997.
But would that be so terrible?
Granted, if this bull, which has rallied for nearly five years without a significant setback, morphs into an official bear market, investors would certainly have much reason for worry.
There have been 10 official bear markets — defined as a drop in equities of at least 20 percent — since 1946, based on the Standard & Poor’s 500 index of widely held stocks. Those plunges, on average, have erased nearly a third of the market’s value over 490 calendar days, according to S.& P. Even worse, the market has needed an additional 669 days, on average, to make up those grisly losses.
But what if the market sell-off doesn’t go that far? What if, instead of a bear market, stocks simply slip into a plain old correction?
Certainly, the odds are much greater that stocks are headed for a correction — defined as a loss of 10 percent or more — than a bear market.
Since 1928, there have been 87 corrections in the S.& P. 500, according to a recent tally by Ned Davis Research. That works out to slightly more than one a year, though since the end of World War II, there have been significantly fewer such downturns. In contrast, there have only been 23 bear markets over the last 80 years.
More important, corrections are far less destructive than many investors assume.
For instance, since 1946, corrections in the S.& P. 500 have driven down stock prices by about 14 percent, on average. Given that equities are already off by about 5 percent since July 19 — and have fallen as much as 11.9 percent if you count intraday highs and lows for the S.& P. 500 — the market may have already sustained a good percentage of its potential losses. (Again, this is if we’re headed for a correction and not a bear market.)
Even if this turns out to be a severe correction, the situation may not be all that bad.
Historically, corrections have lasted only about a third as long as bear markets. In fact, the 16 corrections in the S.& P. 500 since 1946 have lasted an average of only 148 calendar days. And several recent corrections have been far shorter.
For example, the three corrections in the late ’90s — in 1997, 1998, and 1999 — lasted only 51 days, on average. By comparison, the sell-off that began on July 19 is already 45 days old.
Investors may also be surprised to learn how quickly stocks recover their losses after a correction.
Indeed, since 1946, it has taken the market just 111 days, on average, to rise to pre-correction levels. “So it’s about eight and a half months total on the way down and then back up,” said Sam Stovall, S.& P.’s chief investment strategist.
Investors should take some comfort in that, given that they are supposed to be in equities for the long term. (In fact, they shouldn’t even be in stocks if their time horizon is only eight and a half months.) At the very least, Mr. Stovall said, the speed at which markets historically recover should give investors confidence “not to react so hastily to the current troubles.”
To be sure, no one is wishing a correction on this market. But corrections “are a healthy means of relieving the excesses in the market and of restoring a healthy respect for risk,” said James B. Stack, editor of the InvesTech Market Analyst, a newsletter published in Whitefish, Mont.
That has already happened in this sell-off. Consider that investors who had been betting big on volatile assets — like small-capitalization stocks and shares of companies in the emerging markets of Asia, Eastern Europe and Latin America — have lost much of their appetite for risk.
In fact, over the last month, shares of high-quality blue-chip domestic stocks have held up better than small-cap stocks. And mutual funds that invest in the stable developed markets of Western Europe have lost less than funds that invest in emerging-market stocks.
Some investors say they think that the market is already in correction territory, and for this reason: If you count the intraday highs and lows of the market and not just the closing prices, the S.& P. 500 declined by nearly 12 percent from July 19 to Aug. 16.
But the purists say this doesn’t count because market corrections have historically been defined by the closing values of the S.& P. 500 and other stock indexes. Still, even on that basis, the S.& P. 500 recently came within a hair of slipping into an outright correction: from July 19 to Aug. 15, the market tumbled 9.4 percent, based on the S.& P. 500’s closing prices.
OF course, whether or not we’re technically in a correction, a sell-off of this magnitude was long overdue.
Historically, corrections are supposed to be routine events. Yet it’s been about four and a half years since investors have lived through a good old-fashioned correction — at least one that didn’t devolve into a bear market.
The last official correction was from Nov. 27, 2002, to March 11, 2003. Over that short period, the S.& P. 500 slumped 14.7 percent.
But that correction, in particular, offers investors a good lesson. Even though you may be scared to stay the course amid rising volatility and falling stock prices, keep in mind that corrections can shift back into bull markets just as quickly as bulls slip into corrections.
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com.
