Now that the markets have retreated a bit, as they always do eventually, we’ve started to see the commentators blather on with their endless speculations on where the markets will go from here. One particular subject of discussion is about whether this is a correction or not. Just the other day I heard one reporter say that it is important if the Dow Jones reaches a certain level because if it did, we would “be in a correction!”
To understand what a bear market and a correction are, you need to understand Dow Theory a little. Previously I wrote about a pet peeve of mine – reporters and market commentators trying to distinguish between corrections and bear markets based on percentage changes – in a blog post from a few years ago. You can find that post here if you want to be smarter than your friends. The bottom line is that a correction and a bear market are both market events when stock prices decline, with a correction being one move down, followed by a resumption of the upward trajectory, and a bear market consisting of at least two legs down. A trader didn’t feel like teaching Dow Theory to a bunch of journalists, so he just said that a correction is when the market indices go down by at least 10%, where a bear market is when it goes down at least 20%. Journalists are lazy and didn’t bother to learn more, so the definition has stuck and become gospel.
Hey – if you like The Small Investor, help keep it going. Buy a copy of the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy or just click on one of the product links below, then browse and buy something you need from Amazon’s huge collection. The Small Investor will make a small commission each time you buy a product through one of our links.
Where they used to worry about going into a bear market, the commentators are now all concerned if we even hit a correction level, as if that would matter. Now it seems all important if we go down 10% because then we would be in correction territory. It is as if everything is just fine and rosy if we go down 9.9%, but if we hit 10%, the end of the world as we know it will occur. Who knows what would happen if we went down 20% and went into bear market territory? Maybe we’d all be homeless and sleeping in our cars.
Well, I’ve got scary news for you: We are in a correction. It doesn’t matter if the markets go down 5%, 10%, or 90% before they recover. In any of these cases we’ve seen a correction. And now that the markets have recovered a bit from their lows, if they proceed down a second time before they start reaching new highs again, we will be in a bear market. And should any of this matter to you? Not in the least.
The markets are falling for two good reasons. The first is that they went up huge last year, with many indices 20 or 30% plus higher than they were before the Presidential election. Anytime that the stock market goes up like that, people get a little silly about what they are wiling to pay for stocks. Eventually they look at their portfolio and decide maybe they paid a bit much, then try to quietly sell and get out of their positions. If enough people do this, it causes prices to decline, which gets people worried, so they sell as well. Before you know it, you’re seeing a correction. This is normal after a big move upwards.
The second reason is that the economy is starting to do really well for the first time since 2008. The Federal Reserve has been keeping interest rates at near zero for about ten years now. This means that they can’t lower rates much at all should they want to spur the economy. They therefore want to raise rates a bit to give themselves a little breathing room, but have not been able to do so for a long time because the economy has been so sluggish. Now that they are seeing the economy start to grow rapidly, with GDP going over 3% for the first time that anyone born since the millennium can remember, they are taking the opportunity to let off on the gas a little.
They also worry that all of this great news about jobs being created, companies giving out bonuses and raises, and people going to full-time work and spending again, will cause inflation. They therefore want to raise rates to tamp that threat down as well. Because higher interest rates affect the ability of businesses to borrow, raising rates causes the stock market to decline. It is also bad news for current holders of bonds since they see their bonds decline, but it is good news for new buyers of bonds since they’ll be able to get a better rate. It also helps those with savings accounts and money market funds.
What should you do? Nothing that you are not doing already. If you are building up a position and investing regularly, you should continue. If you are getting ready to retire soon, you should have already taken some money out of the markets (enough to meet immediate needs for the next few years) just in case a decline such as this occurs.
If anything, you should try to find more money to invest if you are not planning to retire for at least ten years since at this point, stocks are on sale. You may not get the best price possible (they could decline more if we’re in a bear market), but you’ll get a better price than you did a week ago. And prices will be higher than they are now in ten or twenty years regardless of whether this is a correction or a bear market.
Have a burning investing question you’d like answered? Please send to firstname.lastname@example.org or leave in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
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.