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Stock Market Corrections and Crashes

December 20, 2018

The market has dropped considerably over the last month. Some are calling the drop a correction and others the beginning or a crash. Here are some explanations.

A correction is generally defined as a market drop of 10 percent from its 52 week high and usually follows a bull market. A bull market is when prices increase over an extended period and can separately or collectively apply to every type of investment including stocks, bonds, commodities and real estate. Bull markets keep going up until they don’t…and when the drop reaches 10 percent off of its high, it is called a correction. Bear markets are when prices fall 20 percent from the highs.

Bull markets end when people think the market is overpriced and bear markets end when investors think the prices are too low based on underlying value. I used the word “think” since they are subjective actions, but it is usually widespread aggregate thinking that move the markets.

Some investment categories can be in a bull market and others in a bear market at the same time. That is a reason for a diversified portfolio so that the ups and downs balance each other helping to maintain a relatively stable position. It doesn’t always work that way, but over reasonable time periods it usually provides some equilibrium or stability for the investor. Also, while we refer to the overall stock or bond market it is necessary to qualify what is being referred to since each category has many subcategories. For instance the stock mark can refer to different broad indexes, major sectors, smaller markets or off shore securities.

Corrections occur over a year. If the 10 percent drop is sudden, such as in a day or perhaps a week, but not over a longer period, it is termed a crash. Crashes can lead to a bear market if the drops continue another 10 percent, and that could then lead to a recession, or perhaps cause a recession if the correction or crash leads to a drying up of capital, a period of illiquidity, a lack of consumer confidence, or a flight to safety by people investing in Treasury bonds which is what occurred at the end of 2008 and in 2009. Losses of confidence, regardless of the reality of the underlying performance of businesses, can propel consumers to spend less thereby causing layoffs which then can create a contracting economy, even in the face of strong profitability and employment. This would then continue until it gets to a low point in the cycle (which is only recognized after it starts upward) afterwards which the economy will strengthen.

I certainly do not know what will occur with the stock or the other markets in the near or not so near future. But I do believe one thing – that the U.S. economy will be stronger ten years from now; and that this would be reflected in the values of a broad based diversified stock portfolio, based on present values, by the end of ten years from now. If you believe what I do, then I suggest staying the course. If you do not believe that, then I think you should consider getting out of the market.

This blog is meant to explain and educate and not to make recommendations. I hope you enjoyed it.

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