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Retirement Weekly: Should you be worried about a bear market?

There’s a 61% chance that the stock market correction will not turn into a full-fledged bear market.

I’m referring to the semiofficial definitions of “correction” and “bear market” as declines from a stock market peak of at least 10% and 20%, respectively. The S&P 500
SPX,
+1.93%

satisfied the correction criterion this past Tuesday, when it closed 10.3% below its Jan. 3 closing high. The Dow Jones Industrial Average
DJIA,
+2.32%

so far has avoided slipping into correction territory, but only by the smallest of margins.

There’s no way of knowing whether the market is close to a bottom and will now rally to new all-time highs, or continue declining and subsequently enter bear-market territory. But it is possible to analyze past market declines in order to calculate the probabilities of each.

That’s what I did for this column. From various sources I constructed a list of all stock market declines of at least 10% since the 1920s. Of the 54 declines on the list, 33 did not become eventual bear markets and 21 did. So if the future is like the past, there is a 61% chance (33 out of 54) that the stock market decline we’re currently experiencing will not continue to the point of becoming a bear market.

Your reaction to this will depend on whether you see the glass as half full or half empty. The pessimists among you will note that there is a 39% chance that the correction that began this week will become a bear market, while the optimists will fasten onto the 61% odds that it will not.

Is the risk of a bear market high enough to justify reducing your equity exposure? Only you can decide what is appropriate, given your risk tolerance. But I would note that the risk of a bear market isn’t significantly higher now than at any other time.

Consider the percentage of days since 1900 that have occurred during a bear market. Based on a bear-market calendar maintained by Ned Davis Research, this percentage is 33%, not significantly lower than the 39% probability I calculate that the current correction will become a bear market.

What makes a correction turn into a bear market?

Why do some corrections morph into a bear market and some do not? Analysts from time immemorial have tackled that question, and a definitive answer remains elusive.

Take the cyclically-adjusted price/earnings (CAPE) ratio, which was made famous by Yale University finance professor (and Nobel laureate) Robert Shiller. It is perhaps the most popular indicator of stock market valuation, and you might very well wonder if those corrections that became bear markets had higher CAPE ratios at their starts than those that did not.

Yes, but not by enough to write home about. At the beginnings of those corrections that did not become bear markets, the median CAPE ratio was 17.9. At the beginnings of those that did become bear markets, in contrast, the median CAPE was 18.3. This difference was not significant at the 95% confidence level that statisticians often use when determining if a pattern is genuine.

I reached a similar conclusion when testing the ability of the traditional (unadjusted) P/E ratio to predict which corrections would become bear markets.

In other words, despite whatever other insights that the CAPE and P/E ratios can provide us about the current stock market, they can’t help us guess whether the current stock market correction will be like the 61% of past corrections that did not become bear markets—or like the 39% that did.

The bottom line? The risk of a bear market is not insignificant. But, then, it’s always considerable. We’ve always known that stocks’ higher long-term return is compensation for incurring that risk. What’s happened since the beginning of the year has reacquainted us with this risk in a very practical, non-theoretical way.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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