Bear Markets, Recessions, And The Arbitrary 20% Decline

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Includes: DMRL, EPS, IVV, PPLC, QQQ, RSP, RVRS, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXV, SPY, SSO, UPRO, USMC, VFINX, VOO
by: ANG Traders
Summary

The 20% definition of a bear market correction is arbitrary.

Corrections are normal without triggering bear markets.

Bear markets start only if the correction breaks below the primary trend-line (regardless of the 20% rule).

Without fail, bull markets accompany economic expansions. Also, without fail, both bull and bear markets experience corrections, and these corrections are of varying depths. Bear markets are the opposite of bull markets; the primary trend is up in bull markets and down in bear markets. Corrections, in both bull and bear markets, do not change the primary trend. So, why does the media use the arbitrary -20% threshold to declare bear markets even if the primary trend stays in tact? Why 20%? Why not 15%, or 25%? Nobody knows the answer, but our guess is laziness. The media is too lazy to question the consensus view.

David Rice calculated (see here) when corrections were accompanied by recessions and when they were not. His study showed that since the early 1970s, of the six corrections that were accompanied by recessions, two of them were of less than 20%, and of the six corrections that were not accompanied by recessions, one was greater than 20%. The 20% rule does not differentiate between simple corrections and bear markets.

Bear markets are different from simple market corrections not because they fall 20% (as Rice showed, some bear markets dropped less than 20%), but rather because they are accompanied by economic contraction (recession) and a breakdown of the technical primary-trend. Simple corrections do not fulfill either of these criteria, even if they fall more than 20%.

In addition, there is a substantial difference in the duration of simple corrections and true bear markets. The former last an average of only 4.7 months, while the latter are 13.0-months long, on average. The present correction has been steep but short, lasting less than three months.

We maintain that as long as the primary trend line is not breached and the economy continues to expand, any correction, regardless of whether it is greater than 20% in magnitude or not, should be considered a normal correction within the ongoing bull market.

Primary Trend

The simplest determination of a market's primary trend is to visualize it on a linear scale (chart below).

Source: ANG Traders, Stockcharts.com

A correction within a bull market enters bear market territory if it breaks below the primary trend line. And a correction within a bear market, becomes a bull market when there is a break above the primary trend line.

In the above chart, we use a linear, rather than a log-scale to plot the primary trend because it is simple and clear. The log-scale chart, however, can confuse the situation since it is conducive to drawing a number of different trend lines.

To work around this complication, we apply a Raff Regression on the log-scale chart. Notice that the extrapolation of the lower channel line (red dashed line) has not been breached. In the past, a breach of this extension has signaled the start of a bear market (green ovals on chart below) just like on the linear chart.

Source: ANG Traders, Stockcharts.com

The S&P 500 still has some way to go before it is in danger of breaching the lower channel line (green oval on chart below), and since the market is technically oversold at this point (red ovals on chart below), it is unlikely to have enough selling momentum left to accomplish the breach.

Source: ANG Traders, Stockcharts.com

Fundamental Under-Pinning

Since 1955, there have been eight recessionary periods. In advance of each one of these recessions, the year-over-year (yoy) rate of change in the GDP was declining (red lines on chart below). Notice that, at the moment, the yoy rate of change in GDP is increasing (green line) which makes the current drop in the market less likely to develop into a full-blown bear market.

Source: ANG Traders, FRED

Also, the last three recessions were preceded by an increase in delinquency rates on commercial loans (red lines on chart below). At the moment, the delinquency rate continues to decline (green line) which further supports the idea that we are experiencing what will turn out to be a simple, if rather painful, correction within the ongoing bull market.

Source: ANG Traders, FRED

In conclusion, the ongoing economic expansion and the technically oversold position of the market makes a breach of the primary trend line - and start of a bear market - a low probability event, regardless of whether it declines 20% or not.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.