How Do We Know When A Stock Market Correction Will Turn Into A Bear Market?

The stock market has had a tough go recently. Investors are nervous, scared even. One big question is on everyone’s mind: Does the recent correction signal that we are headed towards a more serious bear market?

There’s good reason for that concern. A Bear market is much more dramatic and damaging than its less severe, and more frequent counterpart – the correction. Corrections are market pullbacks in the 10% but less than 20% range. While corrections have happened frequently over the course of stock market history, corrections that turn into bear markets are more often than not, coupled with an economy headed into or already in recession.

As the old cliché goes, the stock market is not the economy, and the economy is not the stock market.

Let’s examine what market pullbacks look like absent of economic recessions. And let’s also look at what stock market pullbacks look like when they happen during recessions.

Turning to historical precedent, we see that since 1987 (over the past 31 years), there have been 20 pullbacks of 10% or more. Our most recent correction of 12% brings that number to 21. Of these, the pullbacks that ultimately became bear markets (corrections of 20% or more) were all associated with economic recessions. During these recessionary periods, market drops averaged 25%. For market corrections not associated with recessions, the average drop was around 14%.

Of course, there’s no way to know for sure when this current pullback ends, as we can’t precisely predict the future. But history shows that from a percentage standpoint, this recent pullback has already gotten close to what average pullbacks look like during non-recessionary periods. This correction (of early 2018) has reached a 12% dip at low point thus far, relative to the average non-recession pullback of 14%. So as long as we stay out of recession, we are already getting very close to average correction levels.

Believe me, I know. Almost all market pullbacks, especially ones where the Dow drops over 1000 points in one day can scare the daylights out of investors, and it’s a normal human emotion to loath losing money. But as long as the economy stays out of recession, for the time being, this correction should stay just that – a correction. And from where I stand, the numbers just aren’t there to support a backdrop of economic recession.

Remember how January started? The S&P 500 rose over 7%. This performance almost made the top-ten list of best starts since 1950; it clocked in at number 11. What does this mean? Historically speaking, strong Januarys bode well for full-year returns.

One canary-in-the-coal-mine for economic recessions is the Rule of 10 from rebound economist Don Rissmiller, of Strategas Research Partners. Rissmiller believes the economy is more likely to enter a recession when the average 30-year mortgage rate combined with the average cost for a gallon of gas is more than 10.

If we plug in today’s numbers into this equation, we have a roughly 4.5% mortgage rate plus $2.60 for a gallon of gas, which gives us 7.1, safely below Rissmiller’s key number of 10. While this is just a rule of thumb, it serves as a good reminder that high mortgage rates and gas prices play a significant role in slowing the economy – economic data points that are still safely below where they begin to damage economic growth.

Now let’s focus on nine other economic factors that seem to indicate that we probably aren’t headed for a recession just yet:

1. The US Conference Board’s Leading Economic Index (LEI) projects continued expansion and economic growth.

2. The Institute for Supply Management pegs manufacturing in the high 50s, which also indicates robust expansion.

3. Our US unemployment rate is heading lower form 4.1%, not higher.

4. Similarly, US wages are moving upward, currently at 2.9%.

5. The National Federation of Independent Business(NFIB) Optimism Index is at 107, which also indicates economic expansion.

6. There is also optimism (signaling more expansion) per the Consumer Confidence Index, which measures the degree of confidence that individuals have about the economy in regard to their saving and spending outlook.

7. While interest rates are slowly rising, they remain historically very low.

8. Corporate earnings continue to ratchet higher.

9. The recently enacted tax reform will likely continue to boost the economy in the coming years.

And there we have it. Nine solid factors that all point to continued economic growth and expansion – not an impending recession. But as I’ve said before, no one has a Stargate in their living room; we can’t predict the future. What we can do is look at history, number, and data to create our best-educated guess on where we may be going. If we do this, it’s difficult to see a recession on the near horizon, which should keep stock market pullback in check – for now.

Bottom line: corrections hurt.

As humans, our brains hate losing money, even if it’s on paper. It creates real stress, worry, and fear. But remember this part: as long as corrections heal (and they do), your losses heal.

As we make our way through this correction, and those sure to come, keep your focus on the long game. In my opinion, the only way to navigate the inherent ups and downs of the market is to commit to investing over the long term. Another key ingredient is to remember income investing, which can help get us through these tumultuous times.

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