By Peet Serfontein.
Understanding the differences between recessionary and correctional bear markets is crucial. While both scenarios signify a decline in equity market values of 20% from the peak or more, their causes, durations, and implications differ significantly. Recognising the type of bear market one finds oneself in can inform better investment making.
A recessionary bear market is characterised by a prolonged decline in equity market prices, typically by 20% or more, accompanied by a downturn in the broader economy. This type of bear market is often associated with a recession, a significant decline in economic activity across the economy lasting more than a few months.
A correctional bear market is typically a short-term market decline of 20% or more, often seen as a necessary market adjustment in response to equities being overvalued. It does not necessarily coincide with a broader economic downturn.
Strategic implications
In recessionary bear markets, the only response or defence is to be well-diversified. Specifically, investing in defensive sectors like utilities and healthcare and maintaining a long-term focus by looking at strong underlying themes, can help investors minimise losses and potentially take advantage of depressed equity market valuations for long-term gains.
In correctional bear markets, investors can “buy the dip” to gain opportunistic exposure to undervalued equities. It is important to stay informed to identify when a possible rebound could be on the cards. Because momentum is negative it is important to manage your risk by setting stop-losses to limit possible losses.
Examples of recessionary and correctional bear markets
Recessionary bear markets:
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The great depression (1929): The equity market crash of 1929 is one of the most infamous examples of a recessionary bear market. Triggered by excessive speculation and the subsequent collapse of equity prices (up to 89% over three years), it was also a contributing factor to the Great Depression, a severe worldwide economic downturn.
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Dot-com bubble burst (2000-2002): The early 2000s saw a recessionary bear market following the burst of the dot-com bubble. Excessive speculation in internet-based companies led to overvaluation, followed by a sharp decline in technology equities, leading to a broader market downturn and a mild economic recession.
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Global Financial Crisis (2007-2008): This period saw a significant bear market triggered by the bursting of the housing bubble in the United States, leading to the global financial crisis. This was characterised by major declines in equity markets worldwide, and a severe economic recession.
Correctional bear markets:
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The flash crash (2010): Although a very short-lived event, the flash crash was an example of a correctional bear market driven by technical factors. Within a very short period, major US equity indices dropped and partially rebounded, illustrating the impact of automated trading systems and high-frequency trading.
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The 2018 market correction: The late 2018 market correction is a classic example of a correctional bear market. It was largely attributed to trade tensions between the US and China and concerns over rising interest rates. The S&P 500 fell by nearly 20% but recovered the following year as these tensions eased and the Federal Reserve shifted its monetary policy stance.
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The 2015/2016 market correction: Between 2015 and 2016, global equity markets experienced a correction. Factors included concerns over slowing growth in China, falling oil prices, and uncertainty about US interest rate policies. While these issues caused significant market volatility, they did not lead to a prolonged economic downturn.
Examples of recessionary and correctional bear markets
Correctional bear markets often provide savvy investors with many buying opportunities. As prices drop, high-quality equities may be on offer at lower, more attractive prices.
Correctional bear markets:
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Equity prices adjust to more sustainable levels, reflecting their true value. During a correctional bear market, overvalued equities are brought down to prices that more accurately reflect their intrinsic values. This revaluation is a healthy market mechanism that prevents unsustainable asset price inflation.
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This adjustment enhances market efficiency. It ensures that equity prices are a more accurate representation of the underlying company's financial health and prospects.
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The downturn also allows investors to diversify their portfolios by acquiring equities that were previously too expensive. This can improve the long-term resilience of their investment portfolio.
In the short term, investors may experience losses in their portfolios. This can be particularly concerning for those who need immediate liquidity or those who are heavily invested in the affected sectors. However, these losses are often recovered as the market stabilises and begins to rebound. Historically, markets have shown resilience and have recovered from corrections, albeit the time frame for recovery can vary. These markets also often experience increased volatility. Investors need to brace for potentially large swings in equity prices, which can create both risks and opportunities.
