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5% market pullbacks

Over the past month or two, I've mentioned several times in conversations that the market was "overdue" for some sort of pullback. What impact has that had on my personal investing, or the information we've discussed here and in the Sound Mind Investing newsletter? Absolutely none.

Confused? Let me explain. As the chart below shows, we are currently in the sixth decline of at least 5% since the current bull market began two years ago.

Surprised? It only seems like the market has gone straight up for the past two years. In reality, these minor pullbacks happen quite often. Think of them as "the pause that refreshes." Two steps forward and one step back is absolutely normal behavior for the stock market.

Now if you look at this chart and the frequency of these pullbacks, what stands out? Notice the length of the uninterrupted blue line from Sep-10 to Mar-11. Big gains over an extended period without a significant pullback. That simple fact is what has made me feel like some sort of pullback was likely before too long.

If that's true though, then why not do something about it? Well, the main reason is that I just don't have any confidence in our ability to play "the trading game" successfully. Those short-term movements aren't what we're about. It's difficult to know when these pullbacks are coming (note the variation in length between them). And the consequences of riding them out are pretty insignificant (note the overall rising line of the chart, despite these relatively frequent pullbacks).

Here's some analysis from Birinyi Associates, who created the chart (hat tip to The Big Picture, where I saw it):

What is perhaps more encouraging is the fact that 5% declines do not usually result in a further 10% decline, and a bear market is even less likely. An initial 5% decline, such as the one beginning on 2/18/11, only results in a correction (10% decline) 33% of the time, and in only 11 of 106 instances has a 5% decline turned out to be a bull market top.

It's common sense that all bear markets start with a drop of 5%. But only 10% of those 5% drops turn into bear markets. The other 90% don't. Two-thirds of them don't even continue on to 10% official correction territory.

So while last week was a tough week and some people are understandably nervous, there really isn't anything at this point to suggest this is more than a normal pullback within a continuing bull market. In fact, I would go as far as to suggest that even if the horrendous earthquake in Japan hadn't happened, the market would have still found a reason/excuse to sell off by 5% or so soon. It's just the nature of the market.

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