Bull Markets and Corrections

10/07/2013 9:00 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

Stack Financial Management was named to the Barron's 2013 list of the "Top 100 Independent Advisors in the United States" for the fourth consecutive year; here, Jim Stack—in his newsletter InvestTech Market Analyst—looks at the history of bull markets and corrections, and what that portends for the current outlook.

One might actually be surprised to learn that 2013 is currently experiencing the lowest intraday volatility in almost 50 years (since 1965). That's not unusual in a long-term bull market.

When looking at the average historical daily trading range for the Dow Jones Industrial Average (DJI), you'll see that volatility always increases or soars in a bear market. The 2008 financial crisis, and the popping of the Internet bubble in 2000, saw almost three times the volatility that we're experiencing thus far in 2013.

Historically speaking, it would be naive to expect today's low volatility to last—just as it would be foolish to hope the current bull market will last forever.

At 4.5 years, this bull market is already one of the longest since the Great Depression. Looking at the S&P 500 back to 1932, the average bull market duration is 3.8 years and, in comparison, this one is getting a little long in the tooth.

Still, it does have a few peers; of the 16 bull markets over the past eight decades, only five prior to this one lasted more than 4.5 years. Two of those extended bulls (1982 and 2002) peaked just six months later, ending at five years even.

The other three were super bulls which lasted between 6 and 9.5 years in total, which is 20 to 59 months beyond the duration of today's bull market.

Comparing the current bull market to the five previous prolonged bulls, it appears this one has had to climb a more challenging wall of worry.

We looked at the bull markets of the last 80 years that have extended beyond the 4.5 year mark, how many corrections they experienced, and how many of those corrections occurred before the 4.5 year anniversary versus after.

Not surprisingly, the longest bull markets (1949 and 1990) experienced the most total corrections. At 11 corrections to date, this bull market has seen more 5%+ pullbacks in the first 4.5 years than any of the previous extended bull markets. The others generally saw seven or eight corrections during this period.

Among the corrections in this bull market so far, two (in 2010 and 2011) went on to see greater than 10% losses. This is in line with the other prolonged bull markets which experienced zero to three 10%+ corrections in the first 4.5 years.

The more important aspect of our study is what happens beyond the 4.5 year mark. In the three longest bull markets, corrections became more frequent beyond 4.5 years, generally with two to three corrections annually in the final years before the peak (versus one to two annually in the earlier years).

All of the five prolonged bull markets experienced at least one additional 5%+ correction after the 4.5 year mark. Even the two five-year bull markets both managed to squeak in one more 5% correction in the six months before they reached the top.

Among the three longest bull markets, larger 10%+ corrections also appeared to happen more frequently. The granddaddy of all bull markets, from 1990-2000, had the rockiest finale of all, with a greater than 10% correction in each of the three years prior to the final peak.

History suggests that the frequency of corrections increases as the bull market ages. This fact alone could warrant a more defensive stance, but we have also started seeing some initial cautionary warning flags in our technical indicators over the past few months, which is added cause for concern.

While these might resolve, leading to a prolonged bull market, it's prudent for now to remain on the defensive side. Although we risk leaving some potential profits on the table, this strategy is in line with our safety-first philosophy.

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