Do the following words have you holding your head in fear and confusion: recession, depression, bubbles, bull and bear markets? Do you wonder when morning shows use them whether you should be celebrating or stuffing your money into a mattress? If so, you’re not alone. It can all be a bit bewildering. Good news is, we’re here to help. Let’s discuss the history and definition behind all these terms and what they mean for you when the market adjusts.
- Definition: A recession is defined by the National Bureau of Economic Research (NBER) as “a significant decline in economic activity spread across the economy, lasting more than two quarters (which is six months), normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales.” Simply stated, it’s a period of six months during which the country’s economy has declined.
- History: By most authorities, the United States has gone through forty-seven recessions over time. There is some dispute regarding a few of those recessions as unemployment, and GDP data wasn’t captured or standardized prior to World War II. Recessions are typically triggered by a drop in spending as the economy naturally rises and falls.
- Definition: A depression is an extended recession that has two or more years of economic decline. It’s more severe than a recession. It is characterized by a substantial increase in unemployment, available credit drops, housing prices plummet, reduced trade and commerce, and price falls. In layman’s terms, the economy shuts down.
- History: The US had experienced several depressions before the stock market crash on October 27, 1929, but none were as severe or lasted as long. The Great Depression (1929-1939) devastated the US economy. Unemployment rose to 25 percent, housing prices plummeted 30 percent, global trade collapsed by 60 percent and prices fell 10 percent. At the country’s lowest point, 15 million Americans were unemployed and half the US banks had failed. Since the Great Depression, numerous laws and government agencies have been put in place with the explicit purpose of preventing another catastrophic depression.
- Definition: A financial bubble occurs when the price of an asset or commodity rises to levels that strongly exceed the asset’s intrinsic value.
- History: The U.S. has experienced two significant market bubbles over the past couple decades – the Dot-Com bubble of the 1990s and the US Housing bubble in the 2000s. The Dot-Com bubble was triggered by the introduction of the internet and companies achieving multi-billion dollar valuations as they went public. Many experts believe that the bursting of the Dot-Com bubble lead to investors piling into real estate, believing it was a safer option. House prices peaked at 2006. By 2009, the average US home had lost one-third of its value. The bursting of the housing bubble would have a ripple effect on mortgage-backed securities, resulting in a global economic decline that would become known as the Great Recession.
- Definition: A bull market refers to a time when prices of an asset or commodity are expected to rise. The use of the term “bull” comes from the way the animal attacks its prey. A bull thrusts its horns up into the air.
- History: The most notable bull market in recent US history started in 1982 and ended with the Dot-Com bubble burst in 2000. During this time, the Dow Jones Industrial Average (DJIA) averaged 16.8 percent in annual returns, and NASDAQ increased its value fivefold, rising from 1,000 to 5,000.
- Definition: A bear market is the opposite of a bull market. In a bear market, prices of an asset or commodity decline substantially over a sustained period of time. The use of the term “bear” also comes from the way the animal attacks its prey. A bear swipes its paws downward.
- History: The most recent bear market followed the Dot-Com and US housing bubble burst in 2000. From 2000-2009, the market struggled to establish footing and delivered average annual returns of -6.2 percent.
The Bureau of Economic Analysis released second quarter 2017 results for GDP showing an increase at an annual rate of 3.0 percent. This means that the U.S. economy expanded during the first half of 2017.
What a Market Correction Means
While we have enjoyed steady gains in the equity markets in 2017, corrections do happen. When the next correction occurs, we offer the following thoughts for investors to keep in mind.
A stock market correction is often announced with attention-grabbing headlines. The effect can be scary and overwhelming to any investor. It’s hard to stay calm and not panic when bright red numbers and flashy headlines tempt you to take immediate action. Let’s discuss what a correction in the market means and how it may impact you.
How Is the Market Monitored?
The Dow Jones Industrial Average (DJIA) is a stock index that monitors the value of thirty publicly traded U.S. companies. When the DJIA decreases, it is referred to as the market dropping. When the DJIA decreases so significantly that it has lasting effects on the economy, it is referred to as a crash. The market sometimes falls because investors have become cautious about putting their money in one or more companies that the DJIA represents. Factors that can attribute to this include natural disasters, oil prices increasing, economic issues in foreign countries, or a downturn in the U.S. economy.
What Are the Impacts of a Market Correction?
Day to day, market values fluctuate in a fairly narrow band, approximately +/- 2-3 percent. This is normal market volatility. When the market drops slightly, investors are likely to buy stock believing that it will increase when the market recovers. This will earn them a profit. But a more significant fall can decrease the value of the investor’s assets. This can occur for several reasons: the market has become overvalued and the broad consensus of investors is that prices need to adjust, or “correct.” Thus, the name.
In some cases, there is broad consensus that there is deep trouble in the financial sector. That can lead to the type of severe drawdown we experienced in 2008. It turned out that the financial consequences were less severe than investors feared and the actions taken by the Federal Reserve prevented the situation from becoming worse. Investors who resisted the urge to sell profited, in some cases handsomely. The old notion that “panic kills” is very apt in this situation. Investors who liquidated holdings at below fair value locked in losses that can never be recovered.
The status of the stock market is one, but certainly not the only indicator of the overall state of the U.S. economy. If investors and consumers are concerned about their personal financial situation, they may begin spending less money, resulting in a declining economy. However, the linkage between the stock market and the overall economy is not perfect, and it is subject to lags. A market correction is by no means an indication of a recession.
What Should I Do If the Market Drops?
Stay calm and focus on the long-term health of your finances. Financial Advisors take great care to build portfolios to be resilient. Properly diversified portfolios are established commensurate with your level of risk and your long-term goals. While there are no guarantees of future risk and return, there are several appropriate responses to a market correction:
- Rebalance your portfolio. Monitor your portfolio and assess whether your allocations need to be rebalanced to meet your targets.
- Employ tax loss harvesting. Identify losses in your portfolio, and use them to help lower your end-of-year tax bill. You can offset up to $3,000 of income yearly with tax losses, once gains and losses are netted against each other. There are limitations and IRS regulations surrounding tax loss harvesting, so be sure to work closely with your tax advisor.
It is also an excellent idea to meet regularly with your financial advisor to review your financial plan and your progress against your goals. It is also wise to inform your advisor of any changes, such as a different time horizon for your major life events.
Generally, the best thing to do during a correction is to remember long-term investment plans, factoring in short-term market volatility. Don’t let emotional responses drive bad decisions. Talk to your advisor about any concerns you may have before taking action on your own.
by Donna M. Wood, CPA/PFS, CFP®
Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only fiduciary financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. Visit us at www.woodsmithadvisors.com.