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

16 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 S&P/TSX Composite, the FTSE 100 or the Hang Seng. The term bear market typically refers to a decline of 20% or more lasting at least two months.

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

Corrections are commonplace

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

Since 1980, the global equity market* has experienced 12 corrections and 7 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 U.S. stock market's more extensive historical data.

Since 1928, the Standard & Poor's 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 U.S. market during this period has been anything but grim. Indeed, the S&P 500 has produced an average annualized 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 realize 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 days.
  • The average time from a correction's trough to recovery was 121 days. The fastest rally was 46 days, the slowest 359 days.

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 days.
  • average time from a bear market trough to recovery was 798 days. The fastest recovery was 85 days, the slowest 1,928 days.

Global stock prices (January 1, 1980—January 22, 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 January 1, 1980, through December 31, 1987, and the MSCI All Country World Index thereafter. Both indexes are denominated in U.S. 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 6% 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 fixed income and cash can help moderate the impact of corrections and bear markets on a diversified portfolio.

*As represented by the MSCI World Index from January 1, 1980, through December 31, 1987, and the MSCI All Country World Index thereafter. Source: Vanguard and Factset.

**Average annualized returns, January 1, 1928—December 31, 2015: U.S. shares = 9.72%; U.S. 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 U.S. Treasury bills. Source: Vanguard and Factset.

Important information:

The views expressed in this material are based on the authors' assessment as of the first publication date (February 2016), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.

Any "forward-looking" information contained in this material should be construed as general investment or market information and no representation is being made that any investor will, or is likely to achieve, returns similar to those mentioned in this material or anticipated in this material.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

While this information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of this information or any results from its use.

This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations were as of September 30, 2015. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.

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