Unsraveling the Mystery of Market Corrections
In the realm of investing, a correction signifies a decline of 10% or more in the price of a security from its most recent peak. Corrections may occur to individual assets like stocks or bonds or to an index measuring a collection of assets.
An asset, index, or market can experience a correction briefly or for prolonged periods—spanning days, weeks, months, or even longer. On average, market corrections last between three and four months.
Investors, traders, and analysts employ various charting methods to predict and track corrections. The causes of corrections are varied and range from macroeconomic shifts to company-specific issues.
Key Takeaways
- A correction is characterized by a decline of 10% or greater in the price of a security or market.
- Corrections can last from a few days to several months or longer.
- While they may be troublesome short-term, corrections can adjust overinflated asset prices and create buying opportunities.
How a Correction Works
Similar to an unpredictable storm, knowing a correction is on the horizon can be unsettling but doesn’t warrant panic. Historically, the average correction for the S&P 500 spans around four months and results in approximately a 13% drop before recovering.
Novice investors may understandably be anxious about a 10% or greater drop in their portfolio value during a correction. For long-term investors, however, these fluctuations are typically minor obstructions on the path to achieving retirement savings, and the market often recovers over time.
Conversely, short-term traders and those with substantial leverage could face significant losses during periods of market corrections if they are caught off guard.
Although predicting the start, end, or severity of a correction is impossible, analyzing past data allows investors to mitigate risks accordingly.
Charting a Correction
Market analysts sometimes forecast corrections by examining market data and comparing indices. Observing trends can signal an imminent market correction when similarities in performance among underperforming indices become noticeable.
Technical analysts use tools such as Bollinger Bands®, envelope channels, and trendlines to predict corrections by observing support and resistance levels. A technical correction occurs when an asset or entire market becomes excessively overinflated.
Preparing Investments for a Correction
Individual stocks may appear robust or even outperform before a correction. However, adverse market conditions can lead to subpar performances during correction periods, creating opportunities to purchase high-value assets at discounted prices—though risks remain as values could continue to decline.
To protect investments, setting stop-loss orders can help manage declining equity prices. These orders are triggered when prices hit pre-determined levels, although fast-falling prices may still execute transactions differently than expected. Stop-limit orders help mitigate this by setting both target and limit prices, ensuring either execution or acceptable pricing.
Investing During a Correction
Corrections often impact some equities more significantly than others. Small-cap, high-growth stocks in volatile sectors generally react more sharply, while sectors like consumer staples—which produce or sell essentials—tend to remain resilient even in economic downturns.
Diversification offers another layer of protection by balancing assets that counteract one another during corrections. Bonds, real estate, and tangible assets can act as stabilizers against declining equity markets.
Long-term, corrections—despite posing challenges—can benefit the market and investors by adjusting overinflated assets and presenting lucrative buying opportunities.
Pros
- Present buying opportunities for discounted high-value stocks
- Mitigate losses with stop-loss/limit orders
- Stabilize overinflated markets
Cons
- Potentially cause panic and overselling
- Harm short-term investors and highly leveraged traders
- Risk prolonged market declines
Real-World Examples of a Correction
Market corrections are a common occurrence. Between 1980 and 2020, the S&P 500 experienced 18 corrections. Out of these, five transitions led to bear markets—signaling economic downturns, while the remaining bounced back to bull markets—indicating economic growth and stability.
2018 Example
In February 2018, both the Dow Jones Industrial Average (DJIA) and the S&P 500 entered corrections, with each dropping over 10%. Later, in October 2018, the Nasdaq and the S&P 500 again faced corrections. By December, the S&P 500 fell 15% from its peak, reflecting growing market uncertainty.
However, market resilience prevailed, and a rally ensued. By January’s end, all losses for the year were reversed, and by April 2019, the S&P 500 had climbed nearly 20% from December’s lows.
Market corrections can present unique opportunities for those equipped with the proper knowledge and preparation.
Related Terms: Bear Market, Bull Market, Diversification, Stop-Loss Orders, Consumer Staples, Valuation, Real Assets.
References
- CFA Institute. “Rush Hour and Short Cuts: How to Navigate Market Corrections”.
- Schwab. “Market Corrections Are More Common Than You Might Think”.
- CNBC. “The Stock Market Loses 13% in a Correction on Average, If It Doesn’t Turn Into a Bear Market”.
- SEC. “Access to Capital and Market Liquidity”.
- S&P Global. “Performance and Volatility for Sectors in the 2010s”.
- Fidelity. “Consumer Staples”.
- Yardeni Research Inc. “Stock Market Briefing: S&P Bull & Bear Market Tables”. Page 4.
- Schwab. “Market Correction: What Does It Mean?”
- Invesco. “The Bare Necessities: A taxonomy of S&P 500 Bear Markets”.
- Nasdaq. “S&P 500 Joins Nasdaq and the Russell 2000 in Correction Mode”.
- The Washington Post. “Stocks Are Down After a Volatile Year, but That’s Not the Whole Picture”.
- Nasdaq. “Stock Market News for Jan 2, 2019”.
- The Standard. “S&P 500 - 10 Year Daily Chart”.
