Jesse Felder’s “Correction Beard” captured the awe of the financial blogosphere this year.
If you missed it… the former Bear Stearnrns banker and hedge fund manager, and current author of thefelderreport.com, made a public vow in late September 2014:
“I’m growing a beard… and I’m not going to shave it until the S&P 500 drops 10% or more.”
Eleven months later, with stocks failing to falter into official “correction” territory, the bearish-leaning analyst had accumulated this wild beast of a beard:
Let me explain… first, by considering the official definition of a “bear market.”
And then, we’ll try answering the riddle: “When will, or did, stocks enter a bear market?”
A bear market is defined as a 20% drop in price, occurring over two months or longer. Likewise, most agree that a 10% drop qualifies as an official correction (and that’s the line in the sand that Jesse’s beard was minding).
And while these definitions create neat, black-and-white boundaries between the market’s potential phases… it’s important you realize two of their downfalls.
For one, these are artificial lines in the sand.
Who picked 10% and 20% as the “official” cutoff points for defining a correction and a bear market? I have no idea.
They seem quite arbitrary. And what’s more, they have no real or meaningful connection to the actual risk tolerances of real investors.
Many investors can’t afford a 20% loss – either financially or psychologically. And so telling them to hold stocks “until a bear market,” which we’ve arbitrarily defined as a 20% loss, is both imprecise and reckless.
The second flaw in these definitions is one that’s been pointed out by Tom McClellan, of McClellan Financial Publications. In his note, Correctly Defining “Bear Market”, Tom insightfully shows that a bear market doesn’t begin once stocks are down 20%… it actually began months before, when stocks were trading at their highs, 20% higher (even though we only see this in hindsight).
And that’s the point I want to focus your attention to today.
You see, as it stands now, the S&P 500 is NOT yet in a bear market, at least in definition. In fact, it’s only 4% below recent highs – nowhere close to the 20% line in the sand.
But get this… 35% of the individual stocks that make up the S&P 500 are in official bear market territory. And another 27% of them are between 10% and 20% below their highs – already in a correction and flirting with bear market territory.
So when you consider that nearly two-thirds of S&P 500 companies are on shaky ground, it’s hard to take any comfort from the fact that the S&P 500 – as an index – does not yet meet the official definition of a bear market.
And this false sense of security creates a dangerous situation for the typical long-term investor, who is likely being told to “hang on” until we can officially call a bear market.
The point is… by the time that happens, it’ll be too late! A majority of individual stocks will already be down 20%… 40%… or more.
As I see it, this is a perfect example of the proverbial frog in slow-boiling water.
The classic anecdote goes…
If you were to drop a frog into a pot of already-boiling water, it would quickly jump out, immediately sensing the danger and, naturally, taking actions to escape it.
But if you drop a frog in a pot of cool water, then very gradually bring the water to a boil… the frog will cook to death, unable to sense the ever-increasing danger – but only because the danger came about so gradually that it was imperceptible.
Sadly, most investors become “boiled frogs” because they simply focus on the stock market in aggregate – meaning, they focus on the S&P 500 index, rather than its individualcomponents. And they use arbitrary lines in the sand – like the “20% in 2 months” definition of a bear market – to determine when to bail on a bull market.
The good news is… there is a better way!
Next week, I’ll show you how a flexible, self-adapting investment strategy – like my Cycle 9 Alert – can automatically adjust to changing market conditions well before stocks get stamped with the official “bear market” label.
Not only does this strategy prevent investors from becoming boiled frogs, it keeps investors on the right side of profitable trends.
More on this next week…
Chief Investment Strategist, Dent Research