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Investing 101: Defining Pullbacks, Corrections and Bear Markets

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First we had the Hang Seng China Enterprises Index, then 2013’s big star the Nikkei (^N225) got hit. Bear markets are creeping up in global markets, and even among some indivisual high flyers in U.S. like Netflix (NFLX), Facebook (FB) and Priceline (PCLN). While indices that track larger companies like the S&P 500 (^GSPC) is doing much better than high-flying momentum stocks after hitting all-time highs last Friday, our friends from Bespoke are finding that the average stock in the S&P 1500 (which includes small-caps and mi-caps into the mix) is down an average of 12.8%.

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Source: Bespoke Investment Group

As a general proposition, varying slides from all-time highs will have investors asking themselves what stage of market downturn stocks are experiencing. In this installment of Investing 101, Erica Coogan of Moss Adams helps us break down and define the differences between a bear market and smaller downward movements like pullbacks and corrections.

Pullback: typically defined as a 5% dip from a recent high, and often times seen as a buying opportunity during an ongoing bull market. For Coogan, a pullback is a “temporary blip of the peak of the market, almost a ‘sigh’ in upward momentum; it’s very short term, and you’re still continuing up in a bull market.”

Correction: usually a 10% move lower from new highs. It’s more severe in nature, but could possibly just be a healthy dip as some investors take profits and others adjust their risk/reward ratios. The question here is whether companies in general still in good shape, or is the stock market a leading indicator of weakness in the overall economy, and will corporate America be the next area to feel weakness in growth.

Despite a correction being jarring for investors, Coogan says for her and other market watchers “it’s still defined as a shorter-term pullback in a bull market, it’s just a little more significant than the pullback that’s less than 10%”

Bear market: a 20% or great tumble in the market. This 20% downturn is “usually something that’s sustained for a couple months,” Coogan says, where from an investor psychology perspective “pessimism breeds pessimism, and you get that continued downward trend, and that can be hard because you don’t know actually when it could stop.” Thus trying to predict the absolute bottom can be very difficult for an investor trying to time the market, but the risk/reward payoff for those that do can be astounding (just look at the run up from 2009 March lows).

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