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Iron Capital Insights

  • Iron Capital Insights
  • February 4, 2010
  • Todd Smallwood

Correction or Bear Market?

Today’s Insight comes from Todd Smallwood, Iron Capital’s new director of trading. More information below on Todd’s vast experience.

Many investors have been concerned by the drop in the US stock markets from the January highs and are asking if we are in a correction or worse, the beginning of a bear market. Let’s break it down.

According to Vanguard, “While there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period.”* A bull market could be defined as a long period of time when prices are generally increasing. A correction is commonly defined as a price decline of at least 10%, occurring within a longer-term bull market.

To determine where we might be headed from a technical analysis perspective – a study of market action, usually with price charts – it helps to look at where we came from. The bear market in the S&P 500 index started in October 2007, when it began a 57.4% decline from the high (1,564.74) to the March 2009 low (666.79). What followed was an astonishing bull market rally from the March intraday low to the January 19, 2010, intraday high (1,150.45) of 72.5%. The index then dropped 6.9% over the next eight business days to a low of 1071.59 on January 29. Why did we drop? Where does the market go from here?

Rarely have we seen a rally of this magnitude without a correction, yet we have not had a drop of at least 10% since March 2009. As a bull market’s gains continue, short-term investors or speculators typically look for an opportunity to lock in their gains by selling their biggest winners, thus triggering price declines that can lead to a correction. Long-term investors typically remain fully invested through a correction, and avoid trying to time the market to realize long-term gains. A correction is thought to be a healthy event for a bull market because it gets many of the speculators out of the stocks with the biggest gains, creating opportunities for long-term investors like us.

In percentage terms the rally appears overdue for a correction, and several catalysts appeared in late January that may have started the process. First, China announced steps to slow growth (GDP +10.5%) by increasing the Bank Required Reserve Ratio and instructing banks to curtail lending. Additionally, European growth appears shaky as the sovereign debt of Portugal, Ireland, Greece and Spain are under selling pressure due to large deficits and downgrades. As bond prices drop, interest costs rise, leading to reduced funds for government spending. This leads to the fear of slowing global growth, which in turn led to a drop in commodity prices, particularly copper and oil, which both dropped around 13% from the January highs. Finally, the U.S. Administration’s proposals for bank regulations have led to a sell-off domestically, with Bank of America, JP Morgan, and Citigroup all dropping more than 13%, and technology stocks in the S&P 500 have dropped an average 10.6%.

Techs, financials, and commodities have been leading the market higher from the March lows, and now they are signaling that the market may be headed toward a correction.

For the S&P 500 to achieve a 10% drop defining a correction, the index will need to fall below 1,035.40. We would see this as a healthy sign. We are not concerned about short-term corrections that flush out speculators and allow the longer-term bull market to keep moving forward; we are concerned, however, about protecting against a true bear market. At this point we do not see a bear on the horizon, with approximately 80% of S&P 500 companies outperforming on quarterly earnings, but we remain ever watchful.

Todd Smallwood
Director of Trading, Iron Capital Advisors