Market Moves
Corrections, Bear Markets and the Business Cycle
Markets don't rise in straight lines. Declines of 10%, 20% and more are a normal part of investing. Knowing the vocabulary, and the history, makes them less frightening.
The vocabulary of declines
| Term | Common definition |
|---|---|
| Pullback | A modest dip, often 5% to 10% from a recent high |
| Correction | A decline of 10% or more from a recent high |
| Bear market | A decline of 20% or more from a recent high |
| Bull market | A sustained rise, often dated from a 20% gain off a low |
These thresholds are conventions used by investors and the financial press, not official rules. They're usually applied to a broad index such as the S&P 500.
The business cycle
The economy moves through expansions (growth) and contractions (recessions). In the United States, the National Bureau of Economic Research's Business Cycle Dating Committee determines when recessions begin and end, looking at a range of indicators including employment, income, spending and production. The popular rule of thumb, two quarters of falling GDP, is not the official definition.
The committee often announces a recession's start months after it began. Markets don't wait. Stocks frequently fall before a recession is recognized and often start recovering before it ends.
Why markets lead the economy
Stock prices reflect expectations about future profits. When investors expect a slowdown, they sell before earnings actually fall. When they expect recovery, they buy before the data improves. That's why the stock market can rally on a day of terrible economic news: the news was less bad than feared.
Different stocks in different phases
Businesses feel the cycle differently:
- Cyclical companies (automakers, airlines, industrial manufacturers, many retailers) tend to see earnings rise and fall sharply with the economy.
- Defensive companies (utilities, grocery and household staples, many health care businesses) sell things people buy in any economy, so their earnings tend to be steadier.
This is why a low P/E ratio on a cyclical company near the top of the cycle can be misleading: its earnings may be at a peak.
What history suggests
Declines are frequent, and they can be fast. In early 2020, U.S. stocks fell more than 30% in about a month as the pandemic hit, then recovered faster than almost anyone expected. Other bear markets have lasted much longer. No pattern guarantees how the next one will unfold.
The long-term view. Over long periods, broad U.S. stock indexes have historically risen despite many corrections and bear markets, but past performance does not guarantee future results, and individual stocks can fall and never recover.
Thinking clearly in a decline
- Know your time horizon. Money you need in the next few years generally doesn't belong in stocks.
- Write down your plan before a decline, while you're calm.
- Look behind the chart: is the company's business actually damaged, or is it falling with everything else?
- Check your dividend safety numbers; recessions test them.
Turn a start value, end value and years into an annual growth rate.
Common questions
What is the difference between a correction and a bear market?
By common convention, a correction is a decline of about 10% or more from a recent high, and a bear market is a decline of 20% or more.
Who decides when a recession starts?
In the United States, the National Bureau of Economic Research's Business Cycle Dating Committee identifies the peaks and troughs of the business cycle, usually well after the fact.
Should I sell when the market drops?
That depends on your goals, time horizon and situation. Historically, some of the market's best days have come close to its worst days, so investors who sell after a drop can miss the recovery. This is education, not advice.