NEW YORK (CNN/MONEY) -
It's not unusual for the stock market to pull back a year or so into a major bull market. Such "corrections" -- which typically last for a few months and cause a double-digit decline in the Dow -- normally are followed by a resumption of the bull market, which then goes on for another couple of years.
The current correction, which began in February and has so far knocked almost 10 percent off the Dow, could easily be dismissed were it not for all the problems in Iraq. Many investors seem to fear a debacle that would send the stock market into a much more serious and longer lasting tailspin.
So, is this recent selloff a correction that has nearly run its course or the beginning of a bear market?
Is it the economy...
Corrections normally occur after the first year of a recovery for a couple of reasons.
When a recession ends, corporate earnings are deeply depressed. Once the recovery starts, earnings bounce back fast, with initial gains that are much higher than companies' core growth rates. Stocks follow and sometimes soar too high, often leading to a correction.
Corrections also happen because the start of an economic recovery causes an uptick in inflation and interest rates. In fact, that's a good sign because it means that strong growth is under way. Nonetheless, investors worry that too large a rise in inflation and interest rates will cut short the recovery.
Neither of these factors is grounds for believing that this bull market is over. Stock valuations have been only a bit above normal and the decline of the past four months has eliminated most of whatever excesses there were. And the prospective upturn in inflation and interest rates is completely within normal bounds.
In fact, although bond prices typically suffer as soon as interest rates start up, stock prices usually don't feel any adverse effect until the Fed's third or fourth rate hike. Barring a severe external shock, the bull market could easily resume and gain more than 20 percent over the next two years.
...or is it Iraq?
To see how bad things could get, it helps to look at the scale of past recoveries and corrections.
During the second half of the 20th century, there were nine bull market corrections. On average they lasted four months and caused a 16 percent drop in the Dow. The actual declines ranged from 9 percent to 19 percent, with one exception -- the 1962 Cuban missile crisis, which provoked a 37 percent market decline.
There were two other major selloffs caused by external shocks rather than corrections. And they show what sorts of events could make the current decline far worse.
A massive and seemingly permanent runup in oil prices -- to levels far higher than today's, if you adjust prices for inflation -- caused back-to-back recessions in the 1970s.
And the massive overvaluation of stocks, combined with a surprise run-up in interest rates, triggered a brutal crash in 1987.
We don't see the gross overvaluation of stocks today that would precede a repeat of the 1987 crash. It's possible, of course, that a far worse oil crisis could develop or that conflict in Iraq could somehow provoke a nuclear exchange somewhere in the world or some form of nuclear terrorism. And you should remain defensive to protect your portfolio to whatever extent possible against such events, even if they're unlikely.
Nonetheless, unless you're a profound pessimist, you should recognize that the current correction is most likely two-thirds over. The next month or two is a time to sit tight and ride out any further decline or, if you're a bit aggressive, to go bargain hunting. The resumption of the bull market after a correction is never guaranteed, but it's certainly the way to bet.
Michael Sivy is an editor-at-large for MONEY magazine. The Sivy on Stocks column and newsletter will be available only to MONEY subscribers and AOL members. Subscribe now and you will also receive access to the Sivy 70 -- our exclusive list of America's Best Stocks -- and coming in June, to Sivy's Guide to Growth. Click here to subscribe to MONEY and to sign-up for the Sivy newsletter.
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