Let's put the current stock market sell-off into perspective.
A bull market began in March 2003. It was just shy of its fourth anniversary at the most recent high on February 19. The FTSE-All Shares index then dropped five per cent in the next nine trading days.
A very tiny bounce on Friday, March 2 (Day 10 since the peak) led many investors to hope the late-February sell-off had run out of steam and a fresh rally would soon begin.
Unfortunately, another sharp drop on Monday March 5 (Day 11 since the peak) marked paid to that optimistic hope.
So, what lies ahead? Are we currently in a bull or a bear market? The experts are divided. Some believe the sell-off is almost over and shares will soon continue to rally. A second group also thinks the four-year-long bull market is still in progress although the current short-term decline has further to go.
The third group claims the bull market of 2003 to 2007 is now over and substantial declines lie ahead.
Which point of view should we trust in? History offers this objective perspective.
A brief note of caution before diving in. Investors must not go back too far in time for this type of historical analysis. The world's stock markets move quite fast these days. Comparing today's stock market swings with trends that existed in the 1950s or '60s might lead to inappropriate conclusions. For this reason, we elected to focus on price fluctuations from the more recent past, the last quarter-century.
Since 1980, there were 64 short-term declines of at least five per cent. . In other words, short-term sell-offs occur much more often than most investors would guess. The length of time between the end of one short-term correction and the start of the next is a little over three months, on average
Even during bull markets the gap between the completion of one correction and the start of the next is about five months, on average.
Viewed from this angle, there is nothing very special about the suddenness of the current down-turn, despite the headlines. February 19 marked the completion of a slightly longer-than-average rally that had been running since the last big sell-off ended in mid-June 2006. History tells us the current sell-off was a bit overdue.
History also teaches that sell-offs like the current one typically occur in a bull market. Let us put a little flesh on this issue.
There were 26 occasions in the last few decades when a healthy sell-off occurred after a lengthy rally like the one that ended on February. A bull market continued after 25 of these 26 brief sell-offs.
We all know that our stock market is affected by forces outside of our control in places like New York, China, the Middle-East. Even so, past trends hint that the current bull market is not yet over.
On the other hand, history also warns us to be cautious during the next month or so. It is not common knowledge but the average short-term decline in the last quarter-century ran for 32 days.
Just seven of the 64 (or11 per cent) ended within 10 days.
No guarantees of course but the historical odds suggest there is more downside to come before this sell-off runs its course.
Looking further into the future, history warns us to monitor the length of time that the next rally runs. Short bounce-back rallies can be an important warning sign that the bull market is over.
By way of example, there were 16 occasions since 1980 when a sell-off like the one we are currently in was followed by a bounce-back rally that ended within 20 trading days. All but two of them were associated with a bear market.
Viewed from this perspective, the length of the next rally is worth monitoring very carefully.