Outrunning the bear market

by By Alexandra Twin, senior writer
Wednesday, June 2, 2010provided by

After the Dow’s worst May in 70 years, the threat of the stock correction becoming a full-blown bear market has intensified.

But this isn’t new territory for long-term investors. They’ve faced this precipice 29 times since World War II, according to Standard & Poor’s chief investment strategist Sam Stovall.

In 17 cases, they’ve avoided seeing a correction (a decline of at least 10% off the highs) turn into a bear market (a decline of at least 20% off the highs).

In 12 cases, they weren’t so lucky. And in three of those 12 cases it became what Stovall calls a “mega meltdown,” or a decline of 40% or more. In fact, the 2008-2009 stock market bloodletting sent the S&P 500 crashing 57% from an all-time high to a 12-year low.

But as the correction vs. bear market debate continues, what seems to be critical, at least on the technical side, is that the selling not surpass 15%. Historically, if that happens, the correction will become a bear market.

So far this current correction has avoided that 15%. At its worst, the S&P 500 was down 12.3% off the highs. As of Tuesday’s close, the S&P 500 was down 12% from the highs.

But hovering below the 15% mark doesn’t mean the selling is over by any means.

“We don’t know if the market direction is going to be up or down, but we do know it’s going to be up and down day to day,” said Randy Frederick, director of trading and derivatives at Charles Schwab.

The increased volatility increases the likelihood of more selling, particularly with the market in a mode where it retreats on both big news and a lack of news.

The threat of the European debt crisis, the weaker euro, the BP oil spill, increased tensions between North and South Korea and signs that China’s booming economy is slowing all dragged on stocks in May. But there have been numerous days in which there was little relevant news, either on the positive or negative side, and stocks sold anyway. Tuesday’s market, for example.

So correction or bear? Here’s what to consider:

Correction: If the market is in correction mode, it will probably chop around for a few months, then move higher, according to Stovall.

Of the 17 times that the correction didn’t become a bear market, stocks lost an average of 14% over a four-month period. Typically it took stocks another four months to get back to breakeven, and another four months of gains before another correction or pullback kicked in.

A pullback is considered a decline of 5% to 9.99%. They happen frequently and like corrections, are part of normal market functioning. Stovall estimates there have been more than 50 since World War II.

There were only two times (1955 and 1997) that the market “corrected,” recovered and then turned lower right away. More often, the market gets back to breakeven and then gains an average of 10%.

Bear market: S&P research shows that when a correction becomes a bear market, it tends to stretch on for 14 months and yield a decline of 33%, on average. The recovery back to zero tends to take nearly two years.

Stocks currently appear to be in a “garden variety bear market,” pushing toward a decline of 20% to 30% as the mountain of problems becomes too much for investors, according to the editors of the Stock Trader’s Almanac.

Heightened investor worry: In what could be either a bad or good sign, depending on whether you’re a contrarian, investor sentiment took a turn for the worse last week, according to the latest survey from the American Association of Individual Investors (AAII).

Bearish sentiment, or the expectation that stocks will fall over the next six months, jumped 17.2% to 50.9%, marking the highest level of pessimism in the survey since November 2009.

Also, AAII’s monthly survey showed investors pulled money out of stocks last month and reallocated it to bonds, cash or cash equivalents, reflecting global jitters and the fear of further stock erosion.

Investors held just 50.9% of their portfolios in stocks and stock funds in May, down 9.5% from April. That’s the smallest percentage in stocks since May 2009, shortly after the market bottomed. It’s also below the historical average of 60% http://ca.finance.yahoo.com/personal-finance/article/cnnmoney/outrunning-bear-market-20100602