A Primer: Corrections vs. Bear Markets

What’s the difference between a correction and a bear market? The conventional definition is that the former is a drop in stock prices that falls short of a 20% decline. Anything beyond that is a bear market. A correction tends to be caused by falling valuation multiples (P/Es), triggered by fears that earnings will drop. If earnings remain stable or continue to rise, contrary to expectations, then the P/E rebounds and the bull market resumes. If earnings do fall, then P/Es may continue to do so too, resulting in a bear market. So corrections are panic attacks that aren't validated by the fundamentals. We had a nasty correction two years ago and another one last year. It is happening again this year:

(1) During 2010, the S&P 500 forward P/E dropped 22% from a high of 14.7 on January 11 to a low of 11.4 during August 26. However, forward earnings rose all year. So the 16% correction in the S&P 500 from April 23 to July 2 was reversed by the end of the year, with the P/E ending at 13.1.

(2) During 2011, the P/E fell 25% from 13.6 on February 18 to 10.2 on October 3. Forward earnings rose during the first half of the year and remained mostly flat during the second half at a record high. So once again, the market recovered and closed higher by the end of the year with the P/E rebounding to 11.7.

(3) During 2012 so far this year, the P/E peaked at 13.0 on March 26. It was down 11% to 11.6 yesterday, just about matching the 2010 low, which was 11.4. The S&P 500 is down 9% from its high on April 2, which is still just a garden-variety correction. Meanwhile, forward earnings rose to a new all-time record high of $111.27 during the week of May 31. At this level, a retest of last year’s panic low P/E of 10.2 would push the S&P 500 down to 1135, which would be a 20% decline from the year’s high on April 2.

As you can see in our Earnings & Valuation: S&P 500 Blue Angels, the market’s volatility is attributable almost entirely to the volatility in the P/E. Earnings expectations tend to change more slowly and smoothly. The one exception is during recessions, when both variables take a dive. During the bear market from October 9, 2007 through March 9, 2009, the P/E plunged 32% from 15.1 to 10.2, with forward earnings diving 29%. The P/E actually bottomed at 8.9 on November 20, 2008.

Today's Morning Briefing: Corrections vs. Bear Markets. (1) P/E times E. (2) Corrections are driven by P/E. (3) Bear markets caused by earnings recessions. (4) A review of recent history. (5) Just another correction? (6) Earnings and valuations plunged during Great Recession. (7) A relatively optimistic outlook for revenues. (8) Profit margin going nowhere for a while. (9) Corporate cash flow hit by smaller depreciation expenses. (10) Wisconsin’s winner. (11) PATCO for public employee unions. (More for subscribers.)