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When a correction becomes a bear – and what to do about it

04 February 2016 | Markets and economy

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When does a correction turn into a bear market? There's no universal rule, but there is a rule of thumb.

By convention, a correction is generally defined as a decline of 10% or more in the value of a benchmark index such as the Hang Seng, the FTSE Straits Times Index or the Nikkei 225. The term bear market typically refers to a decline of 20% or more lasting at least two months.

From their high on 21 May 2015 through 20 January 2016, global equity prices lost about 19% of their value. That qualifies as a correction, certainly. Whether it's viewed as a bear market won't be known for a few more weeks, at least.

Corrections are commonplace

Historically speaking, stock market downturns – both corrections and bear markets – are relatively common events.

Since 1980, the global equity market* has experienced 12 corrections and seven bear markets. That works out to an attention-grabbing downturn roughly every two years, on average. Add together all the corrections and bear markets since 1980, and you find that share prices spent almost 30% of all trading days in the midst of a sharp downturn. (This considers daily price returns only. If you're doing what's known as a total return analysis, where reinvested dividends are factored in, returns would be higher and recoveries quicker.)

A similar story emerges from an analysis of the US stock market's more extensive historical data.

Since 1928, the S&P 500 Index, which represents 500 of the largest companies in the United States, has been in a correction or bear market roughly 40% of the time. Cumulatively, that would work out to a market slump lasting about 35 years. But experienced investors know that the long-term performance of the US market during this period has been anything but grim. Indeed, the S&P 500 has produced an average annualised return of about 10%, outperforming lower-risk assets such as bonds and cash.**

Here's one way to put those occasional – and occasionally severe – setbacks in perspective: They were the price equity investors paid to realise long-term returns superior to those of lower-risk assets.

Depth and duration have varied

Some corrections are swift and dramatic. Others are slow and gradual. Similarly, the length of time from a market's low point (its "trough") to full recovery has been similarly unpredictable. Consider a few observations from the global stock market data:

  • The average number of days from the start of a correction to its trough was 87. The fastest decline was 28 days, while the slowest was 124.
  • The average time from a correction's trough to recovery was 121 days. The fastest rally was 46 days, the slowest 359.

Bear markets have generally taken longer to reach bottom and longer to recover:

  • The average time from the start of a bear market to its bottom was 373 days. The fastest decline was 60 days; the slowest was 926.
  • The average time from a bear market trough to recovery was 798 days. The fastest recovery was 85 days, the slowest 1,928.

Global stock prices (1 January 1980–22 January 2016)

  Number Average return Average time from peak to trough Average time from trough to recovery
Correction 12 -13.7% 87 days 121 days
Bear market 7 -33.4% 373 days 798 days

Note: Vanguard analysis based on the MSCI World Index from 1 January 1980 through 31 December 1987 and the MSCI All Country World Index thereafter. Both indices are denominated in US dollars. Our count of corrections excludes corrections that turned into a bear market. We count corrections that occur after a bear market has recovered from its trough even if stock prices haven't yet reached their previous peak.

Surprising, and yet inevitable

The boldface headlines announcing each market downturn always make the turmoil seem shocking.

To be sure, every correction or bear market involves some sort of surprise catalyst that disturbs the status quo. However, such setbacks are inevitable. We expect equity shares to produce higher long-term returns than bonds and cash precisely because they experience occasional downturns. Therefore, Vanguard believes that patience and discipline are the best responses to market turmoil.

Our economic and investment outlook for 2016 underscores the potential benefits of keeping a long-term perspective. Our analysis includes a range of projected outcomes for each asset class in the coming decade:

  • We expect average annual global equity market returns to be centred in the 7% to 9% range.
  • We expect average annual global fixed income returns to fall in the 1.5%-2.5% range. As our report explains, these muted expectations reflect an era of low interest rates and low inflation.

Vanguard's probabilistic forecasts acknowledge that the actual outcomes may be different, of course, but investors have historically earned a risk premium for holding equities through the inevitable setbacks. A balance between equities and lower-risk assets such as bonds and cash can help moderate the impact of corrections and bear markets on a diversified portfolio.

*As represented by the MSCI World Index from 1 January 1980 through 31 December 1987 and the MSCI AC World Index thereafter.
**Average annualised returns, 1 January 1928 – 31 December 2015: US shares = 9.72%; US bonds = 5.41%; cash = 3.49%. Shares are represented by S&P 500 Index. Bonds are represented by Standard & Poor's High Grade Corporate Index from 1926 to 1968, the Citigroup High Grade Index from 1969 to 1972, the Lehman U.S. Long Credit Aa Index from 1973 to 1975 and the Barclays Capital U.S. Aggregate Bond Index thereafter. Cash is represented by US Treasury bills.

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