Recent plunges in the stock market left the Dow Jones Industrial Average more than 10 percent below its recent peak - a decline many market commentators describe as a correction. But what exactly does this terminology mean, and more importantly, what should investors do when faced with this type of market disruption?
A significant change in the value of investments prompts reactions from investors and governments. The danger is when either overreacts.
Different doses of bad medicine
Correction. Bear market. Crash.
All are negative terms commonly thrown around to describe a declining market, but each is a little different. The term "correction" is often associated with that 10 percent decline threshold, but that's just an arbitrary rule of thumb. What is more important about the term correction is that it implies a movement of prices towards a more rational level - a discounting of prices to correct artificially inflated levels. In other words, a step back, but not something that should do long-term damage to the stock market or investors.
A bear market is more serious. This is usually used to describe a sustained decline in prices, which is more damaging because it can mean an extended period of substandard investment returns, and is usually tied to an underlying problem with the economy.
As the name implies, a market crash is something more sudden and drastic. Rather than the orderly retreat in prices implied by a correction or the sustained reaction to bad economic news implied by a bear market, a crash happens suddenly and sharply, and represents emotion taking control of market behavior. At best, crashes are short-lived panics that savvy investors can profit from by taking advantage of temporarily discounted prices. At worst though, crashes can destabilize the financial system and cause genuine economic damage.
The market vs. the economy
The distinction between turmoil in the financial markets and actual economic trouble is important. People often treat the terms "bear market" and "recession" as if they were synonymous, but while they are related there is an important distinction.
A bear market can be driven primarily by a change in perceptions, while a recession is a matter of economic reality with more far-reaching effects. A shrinking of economic activity means lost jobs and real hardship at the household level. It is not just a change in what people are willing to pay for investments, but it causes an actual change in the fundamental value of those investments.
Where the relationship between the stock market and the economy gets complicated is when a bad stock market is serious enough to trigger pervasive economic trouble. This may be a matter of negative returns impacting household wealth and thus dampening consumer activity, or perhaps investor pessimism infecting the business plans of major companies, making them less likely to hire and put money into expansion.
The complexity of the relationship is something of a chicken-or-the-egg question - it can be difficult to tell whether a bear market precipitated an economic slowdown or occurred in anticipation of conditions that were already leading to that slowdown.
The role of government policy
A similar sort of chicken-or-the-egg relationship exists between financial markets and government policymakers. The recent market turmoil involves situations where the reaction of policymakers to market behavior has in turn further upset financial markets.
For a couple years now, the U.S. stock market has played a nervous guessing game about when the Federal Reserve would raise interest rates. The Fed has tiptoed around that decision in an apparent attempt to not upset the markets, but that approach may have backfired. Markets hate uncertainty, and in dragging out the discussion of raising rates over such a long period of time the Fed has prolonged the agony, while in the meantime allowing artificially low interest rates to prop up inflated stock prices.
Another government contribution to recent troubles was China's decision to devalue its currency. This may be the sternest test of China's commitment to a more market-based economy, and so far they are failing that test. Devaluation did not cause China's economic woes, but it came across as a panic move, a desperate attempt at a short-term fix when long-term reforms were needed. When a government acts so erratically, it should be no surprise when financial markets follow suit.
Call it a correction or call it a crash, but by any name such setbacks are simply a fact of life in the financial markets. The important thing for both governments and individual investors in such situations is to keep their focus on anticipating the future, rather than on reacting to what has already happened.
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