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March 05, 2007

Correction or Bear Market?

As usual, Ned Davis Research (NDR) has some interesting data on last week's sell-off in regards to answering the question whether we have entered a bear market. Defining a bear market as a 30% drop in the DJIA after 50 calendar days, a 13% decline in the DJAI over 145 calendar days, or a 30% drop in the Value Line Geometric Index, NDR calculates that there have been 33 bear markets since 1900. The average 5 day decline that began the bear market was 3% with a median decline of 2.3%.

Using February 20th as the peak for the DJIA, the first five days of the current decline cost the DJIA 4.5%. That decline was extended to 5.2% last Friday which was day 6 and I as I write this on Sunday night, the Nikkei is down 2% and the S&P 500 futures are down 43 points. Only 6 of the 33 bear markets had a fist 5-day decline greater than the 4.5% decline we have experienced so far. In two other cases the first 5-day decline exceeded 4%.

Based on this data it would appear that bear markets normally do not start with a large swift decline so the folks at NDR decided to look at the number of 5-day declines that have occurred in past cyclical markets. Defining a bull market as the exact opposite of a bear market – a 30% rise in the DJIA over 50 calendar days, a 13% rise after 145 calendar days, or a 30% upward reversal in the Value Line Geometric Index – NDR calculates that there have been 33 cyclical bull markets since 1900. During these bull markets, there were an average of 5.1 five-day declines greater than 4% and a median of four such declines.

With history pointing to the fact that bear markets don’t usually start with a swift and severe decline, NDR decided to look at corrections in bull markets. Including the current decline, this bull market, which NDR dates from 10/16/02, has experienced 8 five-day declines of 4% of more. Of the previous 33 bull markets, only five had more five-day declines of 4% or more, while two others had eight declines. Interestingly of the five bull markets with more than eight 4% declines, three have occurred since 1987. It is probably fair suggest that this is an indication of increasing volatility over the past 20 years.

History is not necessarily a good guide but it does help to put large positive and negative short-term market swings into perspective. I have no idea whether we are starting a bear market or just enduring another swift and steep correction that appear to be becoming more commonplace over the past 20 years. However, if history is a guide and these sorts of measurements are a guide to a history, a swift decline like we are currently experiencing is more likely to be a correction than the start of a bear market.

Posted by Steve Birenberg at March 5, 2007 09:24 PM in Market