This is actually a repeat from a post I made about five years ago – the last time we saw a big correction. Once again, however, we’re seeing people misuse the terms correction and bear market. My readers are better than a bunch of financial reporters who just parrot the wrong definition they heard. Here’s what the true definitions of a correction and a bear market are, so you can use the term correctly:
Please allow me to address a pet peeve of mine today. That is the correct definition of a correction and a bear market. It wouldn’t bother me so much if just the nightly newscasts got this wrong, but I hear people who should know better such as the Wall Street Journal getting it wrong as well. Please refer your friends to this post and distribute it far and wide for I’d like to stop hearing people incorrectly using these terms.
First of all, the incorrect definitions.
Often on a newscast during a market downturn someone — either the anchor or the person they are interviewing — will say we’re having a correction, but have not yet entered a bear market. They then will present the usual, incorrect definition that a correction is when the market has gone down 10%, and a bear market is when it has gone down 20%. While it is true that the market will tend to decline more during a bear market than during a correction, the correct definition has nothing to do with percentages. (This is like the old joke that a recession is when people are out of work, but a depression is when you’re out of work!)
To understand the correct definition, one must understand a little about charting, trends and Dow Theory. For some basic definitions see the past post on charting: https://smallivy.wordpress.com/category/charting/ . Corrections and bear markets have to do with what kind of trend the market is in. Specifically the long-term trend, which is found using a chart with intervals of a week making up each point in the chart. Normally a Open-High-Low-Close chart would be used in which the opening price, high price, low price, and closing price for the week would be plotted for each point. For an example, see the chart for Harley-Davidson during the 2009-2010 period:
http://finance.yahoo.com/q/bc?s=HOG&t=6m&l=on&z=m&q=b&c=
A stock is in an up-trend if the stock is making higher highs and higher lows, such that a straight edge can be laid on the chart and a line drawn from low to low and the stock does not cross this line. This is known as the trend line. Harley was in an up-trend from mid-February to mid-May of 2010, and as one can see the lows followed the trend line pretty well, such that each time the stock’s price fell to the trend line it bounced off of it and moved higher. A down-trend is just the opposite, where the stock sees lower lows and lower highs, such that a straight edge could be used to connect the highs in a descending trend line. A stock will be in an up-trend, a down-trend, or drawing lines (bouncing between two prices and going nowhere) at any given time.
In order for the trend to change, three things need to happen. For an up-trend: 1) The stock’s price must break the trend line. 2) The stock must fall below the previous low, and 3) The stock must not reach the previous high. For Harley the trend line was broken in early May, the low was broken in mid-May, and the stock failed to reach the previous high later in mid-may, so the stock has reversed from an up-trend to a down-trend (like much of the market in 2010). One could now form a down-trend by connecting the high reached in early May to the lower high reached in mid-May.
Dow Theory looks at the Industrials (the DJIA) and the transportations (the DJ Transportation Index). Each time both of these move down in price (one of the regular downward movements as was seen in the Harley chart) while they are in an up-trend — a Bull Market — it is called a correction. If they both actually change from an up-trend to a down-trend, we are in a bear market. For Harley, it was in a bull trend from February until May, with corrections about once or twice a month. In late May 2010 it entered a bear trend and went all of the way down to $10 before correcting and turning into a bull trend.
I’ve heard that the incorrect definition came from someone one of the shows was interviewing who didn’t want to go into Dow theory, so he just gave the 10%, 20% definitions, probably in a statement like, “If it is just a correction, we may see a decline of 10% or so. If it is a bear market it may go down 20% or more.” Because a correction only requires one down-leg before the stock climbs to a new high, while a bear market by definition requires at least two down-legs, most bear markets will result in a decline of about twice that seen during most corrections. Likewise, a correction of less than about 10% probably would be barely noticed, so the trader was probably just trying to get the relative magnitudes across, not knowing that his rules-of-thumb would become gospel.
Corrections can be much larger, however. An extreme example is the crash of 1987, which now just looks like a small blip on the chart of the DJIA.
http://finance.yahoo.com/echarts?s=%5EDJI#symbol=%5EDJI;range=my;compare=
In that stunning crash the Dow Jones Industrials went from 2596 to 1938 in one day — a decline of more than 20%! Looking at the chart, however, you’ll note there was only one leg down, the trend was never broken, and the spectacular bull market that started back in the early ’80’s under Reagan continued clear until the early 2000’s when it was finally ended by the dot-com bust. Since that time we have been drawing lines.
So, you now know the correct definitions, so please stop spreading the incorrect ones. Also, forward a link to this post to all of your friends to correct the mis-information. I’ll know my quest is done when I see USA Today with the correct definition.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
