There is a 40% probability that the recent correction in the stock market will escalate into a significant bear market.
Last Friday, the S&P 500 (SPX) entered correction territory, defined as closing more than 10% below its high on July 31. To meet the semi-official bear market definition, the U.S. benchmark index would need to decline an additional 10 percentage points.
The 40% likelihood of this further decline is not related to geopolitical factors such as the potential escalation of conflicts in Ukraine and the Middle East or concerns about sustained high inflation and interest rates, which are currently causing anxiety on Wall Street. Instead, this probability is derived from a straightforward analysis of the historical data on how many of the S&P 500 corrections over the past century evolved into bear markets.
To be more specific, an examination of a database containing all S&P 500 declines of at least 10% since 1928 reveals that in 21 out of the 55 cases (or 40%), the stock market eventually fell by a sufficient amount to surpass the 20% decline threshold associated with bear markets.
While it may be disconcerting to think that there's a relatively high chance of being in a bear market, it's worth noting that this probability is not significantly higher than the bear-market odds that apply on any random day. Based on data since 1928, a bear-market calendar maintained by Ned Davis Research indicates that 29.9% of all trading days have occurred during bear markets. Therefore, the current odds of being in a bear market are only slightly higher than at any other time – 40% compared to 29.9%.
Is it possible to extract more precise predictions from the data? If so, such insights weren't found. Various valuation indicators, for instance, offer limited help in distinguishing between corrections that remained shallow and those that transformed into bear markets.
Consider the 33 corrections since 1928 that did not evolve into bear markets. These were associated with an average cyclically adjusted price-earnings (CAPE) ratio of 19.0 at the market highs before the corrections. In contrast, the CAPE averaged 21.0 at the highs preceding corrections that did lead to bear markets. The CAPE reached 31.5 at the S&P 500's summer high, which is in the 95th percentile of all monthly CAPE readings since 1881.
You might wonder if the bear-market odds need adjustment in light of the stock market's substantial rally on Monday, during which the Dow Jones Industrial Average (DJIA) surged by 511 points or 1.6%. However, this rally is unlikely to alter the odds significantly. If anything, the odds could increase, given that large daily gains are more frequent during bear markets than bull markets. Of the 100 largest daily percentage gains in the S&P 500 since 1928, 57% occurred during bear markets, nearly double the percentage for all trading days within bear markets.
Therefore, while the massive daily gain might suggest that the market is more likely in a bear market, one should not jump to conclusions.
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