Don't mistake a correction for a bear market

This is a part of another great email from Mitch Zacks, Senior Portfolio Manager at Zacks Investment Management ?Attn: Wealth Management Group http://www.zacksim.com . I manage my own money, but I love his emails because they are so sensible. Again, they said I could post parts of his letters as long as it was just occasionally and I gave full attribution (which is above).

Saul

Don’t Mistake a Correction for a Bear Market

There is a huge difference between a correction and a bear market, or sustained and prolonged downturn like we saw in 2008. A correction is generally defined as a short, very fast drop in the stock market, based on something that at the time seems like it will bring down the global economy as a whole. But, given a little hindsight, investors realize whatever the issue was that caused the quick drop in share prices, really isn’t anything that has staying power or the ability to cause the global economy to completely reverse course and go from a growth to contraction. The important thing to remember is no one in the history of the market has ever been able to accurately and consistently predict both the top and bottom of the correction. Most of the time, those who try to time them end up selling low, then buying back in at a higher level.

The second hallmark of a correction is the duration and swift rebound back to pre-correction levels. This comes after the realization that whatever caused the correction, which could be anything and nobody knows beforehand what it could be, turns out to be a minor hiccup in an otherwise strong economy.

A bear market on the other hand is a completely different story. Bear markets are generally defined as a drop of 20% or more, again, like 2008, and last on average 18 months or more. They come on slowly with a rolling top, meaning there are usually head fakes where the market will drop a little then rebound and repeat that process a few times. Most of the drop in a bear market occurs during the last one-third of its duration. Additionally, bear markets are, to some degree, able to be forecasted. Bull markets end when there is euphoria surrounding stocks and buying continues while fundamentals are deteriorating. The last remaining bears capitulate and buy in at the top of the market. Essentially, there are fundamental reasons for bear markets to occur. There is no fundamental reason for market corrections. They happen, they are normal and they are a healthy part of any bull market. They are the pause that refreshes.

I do not foresee a bear market on the horizon, but I do see increased volatility and a very real chance the market will correct 10% give or take. Avoid the mistake of panicking and selling your stocks, it’s one of the most common mistakes investors make and why investors almost always trail the market.

Don’t Make Decisions Based on Short-Term Data Points

Recently, we have seen some weak economic data released. There has been much turmoil in emerging markets with assets fleeing into safer havens. We’ve seen two consecutive employment reports that were well below expectations. There has been a slowdown in manufacturing growth, although still growth. GDP growth forecasts by those in the industry are being revised downward. China’s manufacturing sector shrunk for the first time in six months.

Not all of this can be blamed on the horrendous weather conditions much of the U.S. has experienced this year, but it is becoming increasingly clear that the weather could take as much as 0.5% off of GDP growth in the 1st quarter of 2014. However, it’s impossible to predict what affect the weather has had and whatever slowdown it may have caused will just push the growth off to the next quarter when the winter finally ends. Even new Fed Chair Janet Yellen said of recent weak economic data in her appearance before the House Committee Thursday, “part of the softness may reflect adverse weather conditions, but at this point it is difficult to discern how much.”

The point is, the long-term trend of global economic growth is still on track. Investors should not make the mistake of basing any decisions on two months of weak data, especially when some of it could be weather related. Two months does not make a trend and to base buy or sell decisions on a few bad reports would be foolish. Yes, it could cause a correction I talked about above, but there isn’t anything going right now that I can see that would cause the U.S. or global economy to fall back into recession or for stocks to experience a prolonged downturn.

Don’t Fear the Taper

During Yellen’s testimony she reiterated the accommodative monetary policy should remain “appropriate” for some time. Seemingly saying there is no set schedule for the tapering process. However, I believe QE3, while possibly propping up sentiment, isn’t stimulating the economy much at all and could in fact be a drag on economic growth. QE3, despite the small amount of tapering, is keeping interest rates artificially low, which flattens the yield curve and takes away the incentive for banks to lend money out to some of the more riskier borrowers, like small businesses. The risk/reward trade-off just isn’t there, so banks are for the most part holding onto their cash until they can make more of a profit by borrowing on the short end and lending at the long end and pocketing the difference. Once QE3 goes away completely, there is a good chance we will see economic growth accelerate. We’ve already seen that happen in England, which ended its version of QE in 2012 and has since se en their economy grow. Once again, a surprise move by the Fed could cause a short-term correction, but don’t make the mistake of fearing the end of QE3, it could turn out to be bullish.

Putting it All Together

While some recent economic data has been weaker than expected, it doesn’t mean economic growth is going to stop or start contracting. It’s only a few bad data points that, when put in context of overall global economic growth, should be taken with a grain of salt. That being said, if we continue to see a trend like this continue for a sustained period, then it might be time to worry. But I highly doubt that will be the case. Certainly the stock market, which is the best leading economic indicator there is, isn’t indicating there is something fundamentally wrong with the economy as stocks are near all-time highs. Yes, there will most likely be a correction of 10% or more at some point that will feel like the market is crashing, but these things don’t last. None of the ingredients are there for a sustained downturn in the market. So my advice to you is, as always, think long-term and don’t let short-term fluctuations in the market or economic data scare you. The economy, while not soaring, is in fine shape.

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Saul -

Thanks for sharing Mitch Zacks thoughts. Its refreshing to read an even-keeled commentary. It feels like today’s world is dominated by shocking headlines rather than actual analysis.

Eric

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Most of the drop in a bear market occurs during the last one-third of its duration.

I had not thought about this before, and I would have to redo some research to see you whether I agree with the statement but it seems reasonable. I got back in way too early in the 2008/09 mess. I was out and short via a short ETF, which was not the help I thought it would be. But getting back in too soon was costly, I was greedy and wanted great prices, but better prices came.

Saul I think you must have some trading skills, Zacks is not a long-term buy-and-hold service. Are you using Zack’s for entry and exit points? Is there anything you’d like to share with your followers on how you use Zacks and how you think about leaving a stock? As my portfolio gets larger and my typical annual returns are larger than my husband’s income, it is harder to sit and watch corrections. I am learning to use options- but most of the capital I have is in a 401k where I have a brokerage account, but options are not allowed.

FlyGal

I don’t use Zacks system as I can’t imagine buying a stock not knowing anything about it, just because it has a Zack’s #1 rating. I do use Zack’s Home Run Investor which is supposed to be a long term investing newsletter, but the guy writing it usually knows almost nothing about the company other than that analysts are raising estimates. You have to evaluate the stocks yourself and toss away most of them, but I got UBNT and AMBA and others from that newsletter before they got picked by MF RB. Note that there are no discussion boards or other ways of getting the kind of nurturing that you get from MF.

Saul

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Most of the drop in a bear market occurs during the last one-third of its duration.

I had not thought about this before, and I would have to redo some research to see you whether I agree with the statement but it seems reasonable.

Historically, about 2/3 of bear-market losses come in the final 1/3 of the bear market. That’s what creates the left side of the “V” so common at the end of bear markets, after which stocks surge off the bottom.

I highly recommend Ken Fisher’s book “Markets Never Forget (But People Do)” for a lot of interesting statistics and great information about historical market behavior (and, equally fascinating, historical media headlines and pundit opinions during those periods).

Neil

I will always do research, I could not sleep at night if I had my capital tied up in things I did not understand. ButI am always trying to improve my results.

I think your long term record trumps mine, I do not have detailed record to compute it like you do, but I know my starting capital in 1987 and I have grown it at 19% compound rate. So I am trying to pick up additional skills.

I have a degree in numerical analysis, so I did discounted cash flow, but it took me a long time to realize that it was really just a guess about future earnings. I needed to THINK MORE about the business, and calculate less…

I gave up on Value investing and I am looking for those growing businesses, but I do not have long experience there. When things go bad with growth stocks investments get creamed. You run a concentrated portfolio and do not hesitate to get out. I am trying to figure out how I can avoid large losses of capital if I get more concentrated. I have has some stunning winners, but when I diversify I don’t get a great return…

So much to learn…

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When things go bad with growth stocks investments get creamed.

flygal,

The way I think about it is that when things go bad with growth stocks they can lose 70% of their value, but if things go well they can go up 300% or more. If you have only one stock, that is very dangerous. If you have 25 stocks and three or four crash and eight or nine take off and fly, you don’t worry so much about the three or four.

Does that help?

Saul

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