Breaking News
Investing Pro 0
Cyber Monday Extended SALE: Up to 60% OFF InvestingPro+ CLAIM OFFER

What To Know About Stock Market Corrections

By TD AmeritradeStock MarketsSep 16, 2022 04:42AM ET
www.investing.com/analysis/what-to-know-about-stock-market-corrections-200629925
What To Know About Stock Market Corrections
By TD Ameritrade   |  Sep 16, 2022 04:42AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 
 
US500
+0.45%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
DJI
-0.15%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 

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, according to 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 explained.

“They’re also good for investors as a reminder that they shouldn’t confuse their brains with a bull market.”

While not everyone will agree with those sentiments, they do provide perspective.

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 market, economic, or geopolitical factors. Examples include worries over slower earnings growth or a potential recession, or natural or political disruptions such as an assassination, war, or a currency or economic crisis.

“Investors benefit from dividends or price appreciation in stocks,” Stovall said. “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 have happened roughly every two years, according to Stovall. Since 2010, the S&P 500 has had nine corrections—including two that ultimately reached the 20% bear market threshold—ranging from 10.2% to 35.4%. The most recent correction, a slump of as much as 25.4% that started on January 4, 2022 and has yet to recover, reached the 10% threshold in 20 days and touched a recent low on June 17.

In contrast, smaller market pullbacks have happened on average every nine months or so, while bear markets have come around approximately every five years, and recoveries from these corrections and bear markets can be swift or prolonged. A recent example is the correction of late 2018, which recovered to new highs in just over four months after falling 19.8% and hitting lows of 2346.58 on December 26, 2018 (see figure 1).

SPX Chart
SPX Chart

Data source: S&P Dow Jones Indices. Chart source: the thinkorswim® platform.

Correction And Recovery

A stock market sell-off in late 2018 took major indexes such as the S&P 500 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.

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, according to Jeffrey Hirsch, CEO of Hirsch Holdings and editor of Stock Trader’s Almanac. He cited 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 said. “Bear markets 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,” said 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 said. Of course, it’s important to check into other research, as not all studies will agree, and even when they might find a theme in common, past events don’t predict future market behavior.

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 noted. 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 the CFRA. And for the nine corrections since 2010, the S&P dropped 10% from 52-week highs in an average of just 35 days.

“As technology has become a more important part of stock trading, the speed at which corrections develop has increased, on average,” Stovall said. “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 forming a plan. Establish a thoroughly thought-out strategy and a diversified portfolio that fits with your long-term goals and your appetite for risk. Then, stick with your plan.

“Also, think mind over matter,” Stovall said, 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 said.

“Investors can protect themselves by conditioning their mindsets 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 Sell-Off

What should you do when the market goes into correction mode? Much depends on your personal objectives, time horizon, and risk tolerance.

  1. Ignore the noise. If you’re a long-term investor, the proper course of action might be no action at all.
  2. 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.
  3. Tread lightly. If you’re using a sell-off as a buying opportunity, consider using market information like technical analysis and fundamental data to help you select an entry point.

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

Disclosure: TD Ameritrade® commentary for educational purposes only. Member SIPC. Options involve risks and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

What To Know About Stock Market Corrections
 

Related Articles

What To Know About Stock Market Corrections

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Continue with Google
or
Sign up with Email