When new investors in the market hear commentators talk about some of the above terms, this incorrectly injects fear into the conversation.
Certainly, a bear market would be very bad news for the markets, but pullbacks and corrections represent the natural ebb and flow of the market. For example, most investors would say that pullbacks are required to consolidate recent gains before the next push higher of an outperforming stock. Let’s look at each term, and dissect the meaning.
Pullbacks are a very natural process for a stock. Generally, a pullback is defined as a short partial erasing of a bullish run. Typically, these are 2-3%, and are considered to be good “buying opportunities” or entry points for a stock which you want to own. Even the best stocks in the middle of a huge run up will pull back. These stocks often pullback to their 50 day moving average or another natural price level. That is called a support level.
Pullbacks should be distinguished from a reversal. A reversal is when new news about a stock or instrument comes out, and the market reacts negatively. Pullbacks are temporary, reversals could have more permanent effect.
Let’s face it, the market has spoiled us recently by pointing straight up without a pause. This is not normal. In most bull markets, corrections happen once or even twice per year. A correction is defined as a decrease of 10% from the peak. Again, this is a very healthy part of a bull market. Investors that have money sitting on the sideline are lured into the market by the sudden 10% correction. They suddenly find value in stocks that they may have wanted to buy, and this provides the fuel for the next step in a bull market. It is very important to be able to distinguish a correction from our next term… the bear market.
Let’s face it, the market has spoiled us. Yes, I used the same line twice to open a paragraph. We are in the midst of the second longest bull market in history with plenty of reasons for the ascent to continue. Bear Markets are defined as a drop in price of 20% from the prior peak. These are the periods that investors pull in their horns. Sometimes it is called capitulation. In all bear markets, the news gets so dire that investors can’t fathom a turnaround. The investors on the sidelines, stay on the sidelines. Typically retail investors throw in the towel at the worst moment, while institutions prepare for the turnaround. Bear markets can last for months and years, and need a spark to pull the market out.
So, now when you hear about a Correction, or a Pullback you will know what they are talking about. The shrewd investor knows that a pullback is a great entry point for a great stock, and a correction may be a good time to put some money to work, but watch out for those bears!