What is a Stock Market Correction?

Wed Feb 24, 2021, 01:56 pm | by Dan Schmidt | No comments

As we’ve seen for the last decade, bull markets can run for a very long time. But every now and then a bull market will get too far ahead of itself and a sudden drop in prices may occur. When stocks experience a drop like this in the middle of a bull market, it’s called a market correction – the prices are “correcting” back to the natural trend.

Market corrections happen frequently, but predicting them is a tough business. Corrections can occur for a variety of reasons and no two corrections will look exactly the same. But investors should be prepared to encounter them and have a plan of action (or inaction) for dealing with them.

What is a Correction?

Market corrections are loosely defined as a drop in a major index of at least 10%. Not all investors define corrections this way, but 10% is the standard. Corrections can take place quickly or grind down prices over a span of months. Despite the scary nature of corrections, they’re a healthy and necessary occurrence in capital markets. If prices never went down, investing wouldn’t produce outsized returns since risk would be removed. Markets simply need to correct every now and then.

If a correction deepens past 20%, it’s known as a bear market and represents a new trend in market direction. Thankfully, this happens infrequently. According to MorningStar, only 5 of the 24 market corrections since 1974 (defined as a drop of at least 10%) have advanced on to become bear markets. 

Of course, 24 corrections in 46 years means investors should become comfortable with their appearance. Expect a market correction once every 2 years or so and figure out how you’ll deal with a sudden drop in the value of your investments. Corrections are usually short, lasting about four months in duration and the average decline was 13% (provided it wasn’t one of the five corrections to turn into a bear market).

The market experienced two corrections recently if we go by the S&P 500 index: December of 2018 and February – March of 2020. In 2018, the S&P 500 opened at 2782 on December 4th and closed at 2351 on Christmas Eve, a drop of more than 15% in three weeks. After Christmas, the index continued back higher but didn’t reclaim the previous high of 2782 until February 22.

You’re probably more familiar with the most recent correction as the COVID-19 pandemic took hold. The S&P 500 fell nearly 13% from 3380 to 2954 in just 7 sessions between February 20-28. The index bounced back to 3130 by March 4 before plummeting to close at 2237 March 23. Between February 20 and March 23, the index lost a stunning 34% and didn’t regain the 3380 mark until August 17.

How Market Corrections Work

Investors often say stocks take the stairs up and the elevator down because corrections are often quick and harsh. Compared to the slow, steady grind upward seen in bull markets, a correction can be swift and harsh.

The December 2018 correction saw a 15% decline occur over the course of three weeks. The average length of a correction in the last 50 years has been around four months, but all corrections are different. The S&P 500 took from February until September to decline 10% in 2015 but lost 18% between April and September in 2011.

How do market corrections work? If you can answer that, you’ll probably be on your way to matching the returns of the greatest investors of all time. Some corrections occur for no specific reason and the duration can be just as random. However, 10% declines tend to occur more quickly than 10% upticks. Even when corrections turn into bear markets like March of 2020, the declines and recoveries are becoming more and more rapid.

While the averages over the last few decades have shown corrections taking place over periods of months, this data doesn’t take into account the speed in which information reaches the public today. Plus when trades can be done on a smartphone for free, the new trend could see corrections measured in weeks, not months.

What Causes Market Corrections

Corrections can occur for a number of different reasons, but also for no discernible reason at all. There’s always some kind of macroeconomic event hanging over the market – a debt crisis here, political crisis there, etc. Why do some of these events send markets into correction while others are easily shrugged off? 

The truth is that most market corrections probably have a combination of causes. Sometimes the source of the market fear will be obvious, like a pandemic exploding across the globe. Other times, the reasoning can be murky with several possible outcomes or trends taking the blame. A few of the common culprits blamed for corrections include:

  • Unforeseen events like the COVID-19 pandemic in 2020 or the collapse of hedge fund Long Term Capital Management in 1987. 
  • Interest rates
  • Geopolitical events like the trade war with China or the European debt crisis
  • Poor guidance and earnings from large-cap companies
  • Slowing economic growth
  • An “overheated” market coming back down to normal levels

Who Do Market Corrections Affect the Most

  • Market corrections tend to take a bite out of the companies most dependent on growth for their valuation, such as large tech companies or small-cap firms. Companies that are most affected by fluctuating economic cycles often perform poorly during corrections and bear markets, while utilities and consumer staples stocks tend to decline less than the broader market. Although banks were some of the worst-performing stocks during the Great Recession, firms with high dividends also tend to be safer during corrections.

Different Types of Market Corrections

You’ll hear different terminology thrown around on financial media regarding corrections, so getting a handle on the lingo will help understand the news you’re hearing and reading. Here are some of the common terms used to describe market declines (or often in place of correction).

  •  Dip: Everyone knows to buy the dip right? When people say ‘buy the dip,’ they’re talking about a small decline of 3-5% which usually represents a good buying opportunity in stocks. Dips can be ignored by buy-and-hold investors unless they want to use the chance to add more shares.
  • Crash: A crash is a fast decline in stocks, usually taking course over a matter of days or even a single day. The most famous market crash occurred in 1929 when stocks lost 90% of their value. Other notable crashes include Black Monday in 1987 (20% decline in a day) and the beginning of the Great Depression in 1929 (23% in two days).
  • Bear Market: When stocks decline more than 20%, corrections become bear markets and a new market trend is established. US stocks have seen three bear markets since the turn of the century: the Dot Com bubble bursting, the Great Recession, and the COVID crash.

How to Deal with a Market Correction

Market corrections are opportunities. Quality stocks are on sale and savvy investors can add to their positions at a discount. The majority of market corrections don’t signal the end of a bull market and buy-and-hold investors would be well served to just wait things out.

If you’re a day trader, the increased volatility during market corrections also represents an opportunity. If stocks are moving quickly in one direction or another, day traders can profit off these extreme moves. 

But for most investors, market corrections are a good place to do nothing. If you have an investment plan, stick to it and you’ll likely wind up buying stocks at fair prices. If you’re reaching the end of your working years and worry about a correction eating into your nest egg before retirement, consider taking some risk out of your portfolio. But other than that, ignore market corrections and stick to your plan.

Final Thoughts

Market corrections are frequent occurrences in stocks, a reminder that investing is never as easy as it seems during the rages of a bull market. Corrections occur rapidly with stocks declining double digits in a span of weeks or months, but thankfully most corrections are just that – minor blips as prices correct. Only a handful of corrections have turned into full-fledged bear markets over the last few decades.

A bear market is worrisome, but most corrections are nothing to fear. In contrast to the phrase of the day, stocks don’t only go up. Market corrections happen once every two years on average and while you don’t necessarily need to plan for one, you do need to prepare yourself for the inevitable day your stocks take a 10% hit. Do you have the stomach to stick to your investment plan when your losses start mounting? It’s a question all investors should ask themselves before the next correction hits.

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