Knowing your dips from your downturns

When is a market decline a buying opportunity, and when should you be cautious? The answer often lies in understanding the nature and severity of market movements.

Pullbacks, corrections, reversals, bear markets; distinguishing between these terms is crucial to navigating market volatility effectively. In this month’s newsletter, we dissect the jargon and see how you can capitalise on the opportunities, and mitigate the risks, during uncertainty.

Getting to know the types of market corrections

Pullback: A relatively mild, short-term decrease in the prices of assets and typically involves a drop of less than 10% from recent highs.

Pullbacks are normal fluctuations within an ongoing bullish trend, and very common. You’ll rarely experience a year without seeing pullbacks at some point. However, they are usually very brief, with markets soon returning to their original, upward trajectory.

Example: In February 2021, the NASDAQ saw a quick pullback, dropping around 8% over three weeks, largely due to shifts in bond yields and inflation concerns. But this drop was short-lived – the market soon recovered and continued its broader upward trend throughout the rest of 2021.

Correction: A much more pronounced decline in the market which tends to last longer than pullbacks (weeks to months), and defined as a decrease of 10% to 20% from recent highs.

Unlike pullbacks, corrections can signal underlying issues or shifts in market sentiment, but do not necessarily indicate a complete trend reversal. A correction serves to adjust and moderate pricing before resuming the original trend.

Example: In September 2020, after a rapid post-pandemic recovery rally, the S&P 500 experienced a correction, falling just over 10% amid worries about overvaluation and a resurgence of COVID-19 cases. This correction was a natural response to the fast gains seen in the summer months of 2020, and set the stage for future growth.

Reversal:  A change in the direction of a price trend – for example, a bullish direction reversing to bearish, and vice versa. Reversals are significant because they suggest a change in underlying market dynamics. Identifying reversals involves observing technical indicators to confirm a shift in momentum.

Example: The sharp market decline in March 2020, due to the onset of the COVID-19 pandemic, marked a dramatic reversal from the bull market that had been ongoing since 2009. The S&P 500 plummeted over 30%, indicating a shift to a bear market. However, this was short-lived; massive fiscal and monetary stimulus helped markets to start recovering by April 2020, signifying a reversal back to a bullish trend.

Bear market: A prolonged decline in market prices, with declines of 20% or more from recent highs. They indicate deep and widespread pessimism across the market, can last from several months to years, and usually result in significant declines in economic fundamentals.

Example: The Global Financial Crisis, which began in 2007, led to a severe credit crunch and the near-collapse of major financial institutions. The crisis quickly spread to global markets, causing a sharp and sustained decline in stock prices and a broader economic downturn.

Putting them all together

Market volatility comes in various forms, each with distinct traits. An overreaction or a decision driven by emotions can be detrimental to your portfolio. A better way to navigate uncertainty is to understand its nature, and to stick to an investment strategy that fits your risk profile. Here are a few takeaways to keep in mind:

Duration and severity:

• Pullbacks are short and mild. Corrections are longer and deeper.
• Reversals can vary, but they imply a significant change. 
• Bear markets are long and severe.

Market sentiment:

• Pullbacks and corrections may not fundamentally alter market sentiment, and are usually a natural part of market cycles even during bull runs.
• Reversals and bear markets, however, indicate significant changes in sentiment.

Strategic response:

• While timing the market is impossible, pullbacks and corrections lend themselves as buying opportunities if the overall market sentiment remains bullish.
• Reversals accompanied by a change in economic regime may require a reevaluation of your portfolios’ positions. 
• Bear markets may lead to defensive strategies, and a focus on capital preservation.

Staying invested is the name of the game

Volatility and pullbacks, while unsettling at times, don’t necessarily signal a fundamental deterioration in market conditions. Instead, they often represent natural deviations in an otherwise upward trajectory.

Dollar-cost averaging regardless of market conditions mitigates the risk of poor timing, and capitalises on the very nature of market fluctuations. By buying more when prices are low and fewer when prices are high, it’s also possible to reduce the average cost per share. As always, staying invested really is the name of the game here.

Our General Investing portfolios are managed to align with your specific risk level, ensuring that your exposure remains constant even as markets change. ERAA®, our investment framework, uses data to pinpoint where we are in the broader market cycle, adjusting allocations based on the economic regime to keep your risk tolerance at the forefront.