A Typical Correction Or The Start Of A Bear Market?

After an outstanding performance in 2022, U.S. stocks have started the year in a corrective phase. The Nasdaq has already fallen more than a typical correction and at its low this past week was nearing bear market territory. As of January 26, the Nasdaq was down more than -11% year to date and -16% from its recent highs after falling as much as 19% from highs. The S&P 500 was down over -7% year to date and -9% from its recent highs after falling as much as 12% to recent lows. Hopefully, the equity markets are marking an intermediate low. 

The William O’Neil methodology seeks to study past stock and overall market examples to try to help guide investors in present situations. In this regard, my co-author and William O’Neil and Company Strategist Kenley Scott and I recently went back and reviewed previous corrections and bear markets to try to identify the chances that this current correction turns into something much worse.

At this point in time, though the U.S. Federal Reserve is beginning its tightening cycle and likely to raise the Fed Funds rate in the first quarter of this year, corporate profit growth remains strong. As a result, though the recent pullback has reduced stock valuations, it is still possible that rising profit growth will keep the bull market that began in April 2020 intact. 

In our study:

•        We use the beginning point of a correction as the S&P 500 falling at least 9% off 52-week highs and closing below its 200-day moving average (exception in 2006 for an 8% decline due to a lack of volatility).

•        We identify and study follow-through days (FTDs). These are, to quote our founder, Bill O’Neil, the fourth day or more from an established low where the major averages have a “booming gain on heavier volume than the day before.” For historical FTDs, we look for a minimum gain of at least 1.2%, while currently, we look for at least a 1.7% gain.

•        For consistency’s sake, in this study once a FTD occurs, it only fails if it breaks below the low established prior to the FTD within 4 months before the market makes a new high.

•        Overall, out of the 33 instances of corrections that occurred from 1971 to 2021, seven turned into a bear market, while 26 resolved higher. In other words, there has been a roughly a 1 in 5 chance a correction turns into a bear market in the past.

As seen in Table #1 (26 Prior Bull Market Corrections Which Returned to Highs):

•         The average correction in a bull market takes 85 days to reach its final low with a median time of 63 days. At this point in time, we are not near these time spans.

•         In the average bull market, a correction takes 193 days to reach a new high from the previous high and 109 days to do so from the correction low.

•         A typical (median) bull market correction results in a -12.0% pullback. This level has already been reached at recent market intraday lows.

As seen in Table #2 (Seven Corrections Turned into Bear Markets):

•        In the 7 bear markets since 1971, it took 473 days on average and 573 on median to reach the eventual low.

•        The typical loss in a bear market is -39.8% on average, over 3x worse than that of a bull market correction. 

Once the market is in a correction, the three scenarios are:

1)     The market establishes a FTD from lows, then returns to highs (or is not back to highs but is above the 200-day moving average at least three months after the lows with no undercut). This has occurred 18 times.

2)     The market establishes a FTD that fails and undercuts the first low, then establishes a second FTD and returns to highs. This has occurred eight times.

3)     The market threshold for a bear market is met. This could be the case after no FTDs occur or one or more failures of FTDs transpire. This has occurred seven times.

Scenario 1 Example (1996, 2014)

Scenario 2 Examples (2018)

Scenario 3 Example (2007–2009)

Current Market

Our conclusion from the above data is that, at this point, investors should favor the correction rather than bear market scenarios, like Scenario #1 or Scenario #2. This is because we do not see the U.S. economy entering a recession at this time as it did in the 2008 period. However, it is possible that if the Fed overtightens monetary policy, it could push the U.S. economy into a recession and send the U.S. stock market to a much lower level.

The signs we would look for to raise the odds of a bear market would be the undercut of the January 24 intraday lows, the continued failure of mega-cap leadership stocks, a continuing increase in the number of stocks trading below their 50- and 200-day moving average (currently, roughly 66% of the S&P 500 and 84% of the Nasdaq are trading below their 50-day moving average), and, finally, a marked reduction in corporate profits and future profit expectations.

While we do not feel the current market is signaling this outcome yet, we will remain alert for signs this is occurring to alert investors to adopt an even more defensive posture. Meanwhile, the S&P 500 is now four days off its recent lows and could have a FTD any day now.

We suggest remaining patient but also open to adding risk in the event a FTD occurs. In preparation, we would look for better-positioned groups and stocks that are signaling signs of leadership during this downtrend. Conversely, while it may be tempting, we would generally avoid stocks that are broken down (i.e., 40–50% or more off highs). Although bounces from lows can come quickly, these areas have a much tougher path forward, given significant moving average and price resistance levels.

As of January 27, only 24% of 197 O’Neil Industry Groups were above their 200-day moving average. This percentage is not comprised of the secular growth areas we have become accustomed to seeing in a leadership position. Instead, it includes banks, insurance, defensive retail, beverages, oil&gas, transportation, agricultural chemicals, fiber optics, and travel/leisure. Below are a handful of stocks from these groups that screen well from both a fundamental and technical perspective.