Even the best stocks do not move in a straight line. There are many times when shares will go through a major correction and even a bear market. In this article, we will look at what is a pullback, correction, and a bear market, what causes them, and how you can profitably trade when they happen.
What is a pullback?
A pullback is a temporary decline of a financial asset. It usually happens when the asset declines for a day or a few days and then resumes the bullish trend. A pullback is often seen as a pause that happens and lasts for a few days or weeks. It can be seen as a period when a stock declines for a few sessions.
What is a correction?
A correction is a period when a stock declines sharply within a day or a few trading sessions. The only difference between a pullback and a correction is that the latter happens when an asset drops by more than 10% from its highest point.
What is a bear market?
A bear market is also a period when a stock declines sharply within a certain period. It is similar to a pullback and a bear market. However, it is more extreme because it happens when a stock declines by 20% and more from its highest point. For example, in the chart below, we see that the Roku declined by more than 40% between July 2021 and October.
Roku shares in a bear market
Therefore, as you can see, pullbacks, corrections, and bear markets are simply periods when stocks are not doing well. In the next part, we will look at what causes the three market scenarios.
Causes of pullbacks, corrections, and bear markets
Since pullbacks, corrections, and bear markets are periods when stocks decline, the three are usually caused by the same things. Some of the most popular causes are listed below.
Investors always pay close attention to quarterly earnings. These results often show whether a company did well in the most recent quarter and whether the management expects it to do well in the future. Therefore, because of how earnings are important, shares tend to experience major drops or pops.
Snap moves into a correction
For example, the chart above shows that the Snap stock price suddenly moved into a bear market when the company published weak results.
Major macro event
At times, stocks could move into a bear market or correction when there is a major macro event. For example, in 2008, stocks crashed hard after the housing market bubble burst. Similarly, in 2000, stocks declined sharply after the dot com bubble burst. In 2020, stocks declined sharply after the World Health Organization (WHO) declared Covid-19 a global pandemic.
The decision by a central bank can have a major impact on stocks. In most cases, stocks tend to do well when a central bank is implementing an easing monetary policy. This is because such actions lead to more risky trades. A pullback, bear market, or correction can happen when the Fed adopts an aggressive policy. A good example of this is what happened in 2018 when the Fed boosted rate hikes by four times. The chart below shows that the Nasdaq 100 index, which tracks tech companies, declined by 23% between October and December.
Nasdaq 100 in correction
There are other leading causes of corrections and bear markets. For example, a stock can drop sharply when a previously announced merger is canceled. It can also decline when a popular chief executive departs. At other times, a stock can decline sharply because of technical reasons, such as when it moves into an overbought level.
A good model to understand why stocks move into the bear territory is known as the Wyckoff model. This is a relatively old model that explains the five stages that stocks and other financial assets go through. Initially, a stock moves to an oversold level. This is where investors and traders start to accumulate it. At this time, it is usually moving sideways or even dropping.
In the next step, the stock gains some popularity, and demand becomes higher than the supply. As a result, it makes a parabolic move. In the third step, it moves into the distribution phase, and it starts moving sideways. Finally, it starts dropping as the supply becomes more than the demand. As such, the stock keeps dropping. It then reaches a point where it starts rising again.
The chart above summarizes the Wyckoff methodology.
How to trade and invest in a bear market
Bear markets are usually difficult periods for investors who are long the stocks. However, to most market participants, they are usually excellent times to buy quality assets at a relatively lower price. For example, when Bitcoin dropped from an all-time high of $65,000 to $30,000, it enabled investors to buy the coin at a discount.
At the same time, bear markets are usually accompanied by high volatility, which is usually a good time for traders to make money. These traders use several approaches, including price action, to identify buying and selling opportunities during a bear market.
On the other hand, long-term investors use fundamental analysis to buy quality stocks at a relatively lower price. For example, they look at a company’s overall growth rate and balance sheet. A company like Facebook has a strong growth rate, a solid market share in digital advertising, and a compelling balance sheet. By October 2021, the company had minimal debt and more than $64 billion in cash. This means that the company can do well after a major pullback.
A bear market, correction, and a pullback are often difficult times for investors. However, to most people, they provide a good opportunity to make money in the market. In this article, we have looked at how these bear markets work, their causes, and how you can take advantage of them.