A simple article today as investors continue to work through the implications of the past week's partial unwind of the Yen carry trade in response to weaker U.S. economic data, Japan hiking interest rates, and the bubble in AI / Mag 7 stocks potentially popping.
Bank of America recently published a series of charts quantifying how frequently the S&P 500 index has experienced corrections of various depths. As the first chart shows, 5% pullbacks happen very frequently. So often, in fact, that SMI has long suggested it's not profitable for long-term investors to try to avoid them — they're just part of the regular market rhythm.
Corrections that take the market down at least -10% are less common but still happen roughly once a year. That's still too common for most long-term investors to try to avoid, although this is the level at which SMI's bear-market protection systems start paying close attention, searching for specific additional signs of confirmation and further market breakdown.
Market corrections of -15% happen roughly every other year. Translation: If you invest over a 30+ year career and then hold investments through your retirement, you're going to experience a lot of these.
Finally, we get to the true bear markets, commonly defined as drops of -20% or more. As Bank of America's chart shows, these happen every 3-4 years, on average. Another way of thinking of that is that you've got a roughly one-in-three chance each year that there will be a bear market that year!
Conclusions
The normal industry takeaway from this data is "corrections and bear markets happen so frequently that you should quit worrying about them and buy-and-hold for the long run." There's an element of truth to that, certainly as it pertains to the smaller pullbacks and corrections.
But as SMI's work has shown, even among the bear markets (-20% or more), there are bear markets and there are BEAR MARKETS. What's the difference? Whether the bear market coincides with an economic recession or not. Recessionary bear markets tend to do big damage whereas bear markets absent a recession typically don't.
That helps narrow the field a little bit in terms of whether to take protective action as a potential recessionary bear market is taking hold, and how much protective action to take. Our defensive protocols are designed to trigger rarely and try to limit our action to these most dire potential setups.
For those looking for a more active approach than SMI's, the work of our friends at 3Fourteen Research on the subject is excellent. They find that historically only 40% of pullbacks (-5%) go on to become corrections (-10-15%). However, 60% of corrections go on to fall further. So their rule of thumb is to buy the dip on -5% pullbacks but get more conservative (and potentially sell) those pullbacks that follow through into correction range of -10% to -15%.
Of course, that's not a blanket rule, and 3Fourteen would give its clients more specific real-time evaluation of each case. But it's a helpful framework that lines up pretty closely with SMI's. Ignore the small pullbacks and potentially look at them as opportunities to put new money to work. However, when markets fall 10-15%, and especially if recession appears likely, that's the time to start thinking about defensive protection.
