What to Know About Stock Market Corrections

What to Know About Stock Market Corrections

Key Takeaways

    A stock market correction is traditionally defined as a decline of 10% or more from a recent price peak

    Corrections can be triggered by concern over earnings, geopolitical events, and other factors

    Investors can aim to prepare for inevitable corrections by diversifying their portfolios and taking other steps

Stock market corrections happen—it’s a fact of investing life. “Correction” is a term that’s thrown about frequently in the financial media. But what exactly is a market correction? And how can investors spot a correction? What kinds of steps can they take to help them prepare for and attempt to protect against the inevitability of a market correction?

A market correction, as traditionally defined, is a decline of 10% or more from a 52-week high (or other recent peak) in the price of a security or a major benchmark, such as the Dow Jones Industrial Average or the S&P 500 Index. Having established that, what else do investors need to know about corrections?

For starters, understand that a market correction serves a few important purposes, says Sam Stovall, chief investment strategist at CFRA Research. One lesson: markets don’t go up (or down) forever. Also, investors shouldn’t try to outsmart the markets.

“Corrections are good for the markets, as they reset the dials,” Stovall says. “They’re also good for investors as a reminder that they shouldn’t confuse their brains with a bull market.”

Let’s look at a few other basic questions about stock market corrections.

What is a stock market correction?

A correction may result from a reversal of investor optimism and can be triggered by internal, external, or geopolitical factors, Stovall says. Examples include worries over slower earnings growth or a potential recession, or natural or political disruptions such as an assassination, outbreak of war, or a currency or economic crisis.

“Investors benefit from dividends or price appreciation” in stocks, Stovall says. “But if growth prospects are threatened, that’s when share prices fall. There could be a myriad of unprecedented events that might alter investor optimism.”

How often do market corrections happen?

Historically, corrections happen roughly every two years, Stovall says. Since 2010, the S&P 500 Index has had five corrections ranging from 10.2% to 19.8%, according to CFRA. The most recent correction, a slump of 19.8% in late 2018, came within a whisker of the 20% threshold for a bear market.

In contrast, smaller market pullbacks happen on average every nine months or so, while bear markets have come around approximately every five years, Stovall says. The S&P 500 has recovered much of its recent slide; as of mid-March 2019, the index was about 4% below a record close of 2,930.75 on September 20, 2018 (see figure 1).

What to Know About Stock Market Corrections

FIGURE 1: CORRECTION AND RECOVERY. A stock market selloff in late 2018 took major indices such as the S&P 500 (SPX) down about 20% from highs set a few months before. Although the market bounced back within a few weeks, some corrections can take months or even years to recover. Data source: S&P Dow Jones Indices. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

What’s the difference between a correction, a crash, and a bear market?

Definitions of a market correction, crash, and bear market vary slightly, but the distinction mostly hinges around speed. A crash is a “violent and fast correction,” with a market dropping 5% or more in a day or over a few days, says Jeffrey Hirsch, CEO of Hirsch Holdings and editor of Stock Trader’s Almanac. He cites the May 2010 flash crash and “Black Monday” of October 1987 as examples.

A crash or correction may or may not take a market below the 20% threshold that defines a bear market. “Every bear market begins as a correction, but not every correction becomes a bear market,” Hirsch says. Bear markets, Hirsch adds, typically unfold over longer time frames: weeks, months, or years.

What indicators might signal a stock market correction? 

The 200-day moving average, a widely followed technical gauge, is worth following, says Kenneth G. Winans, president and chief investment officer at Winans Investments.

This indicator simply averages closing prices over the previous 200 trading days (one calendar year has about 250 trading days), which many market professionals view as a long enough timetable to squeeze out random “noise” and discern a longer-term trend. For example, a closing price below the 200-day moving average could indicate a potential sell signal, while a close above the 200-day moving average could indicate a potential buy signal.

“Studies show that investors who follow this reduced volatility may avoid major drawdowns and increase risk-adjusted returns,” Winans says.

What to Know About Stock Market Corrections

Are corrections happening faster and/or more often?

Market corrections, and subsequent recoveries, do seem to be occurring with greater frequency and speed over the past two decades, Stovall says. This partly reflects the rise of computer-driven trading.

In the 1950 and 1960s, it took an average of 113 days for the S&P 500 to drop from a peak to a 10% decline. In the 1990s and 2000s, the average 10% peak-to-trough took about 60 days, according to CFRA.

“As technology has become a more important part of stock trading, the speed at which corrections develop has increased, on average,” Stovall says. “The time from a peak to the 10% decline threshold has essentially been cut in half.”

What can investors do to attempt to prepare for corrections?

For individual investors, part of the battle involves simple fundamentals. Establish a thoroughly thought-out strategy and a diversified portfolio that fits with your long-term goals and your appetite for risk, Hirsch says. Then, stick with your plan.

Also, think mind over matter, Stovall says, adding that market corrections are good opportunities for investors to examine their “emotional makeup.”

“Remind yourself that corrections are a natural part of the stock market cycle,” Stovall says. “Investors can protect themselves by conditioning their mind-sets so emotions don’t become their portfolio’s worst enemy, causing them to sell at the bottom.”

3 Tips for Trying to Survive a Market Selloff

What should you do when the market goes into correction mode? Much depends on your personal objectives, time horizon, and risk tolerance. But in the video below, TD Ameritrade Education Coach Michael Kealy offers these three tips:

    Ignore the noise. If you’re a long-term investor, the proper course of action might be no action at all.Be tactical. Many short-term traders take profits on winning trades and establish firm exit points for losing positions. If you’re hesitant to sell, consider setting up a hedge position.Tread lightly. If you’re using a selloff as a buying opportunity, consider using fundamental data to help you select an entry point. 

All investing involves risk including the possible loss of principal. Past performance of a security does not guarantee future results or success. 

What to Know About Stock Market Corrections

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