What is a correction?
In the investment world, a correction is generally defined as a drop of 10% or more in the price of a security compared to its last peak. Corrections can occur anywhere, including individual stocks, indices that track stocks or sectors, commodity and currency markets, or any asset that trades on the stock exchange.
An asset, index or market can fall into a correction either briefly or for extended periods – days, weeks, months, or more. However, the average market correction is short-lived and lasts between three and four months.
Investors, traders and analysts use mapping methods to predict and track corrections. Many factors can trigger a correction. From large-scale macroeconomic change to problems in a single firm’s management plan, the reasons for a correction are as varied as the stocks, indices or markets they affect.
How a correction works
The fixes are like that spider under your bed. You know it’s there, lurking, but you don’t know when it will make its next appearance. Although you can lose sleep on this spider, you should not lose sleep on the possibility of correction.
According to a 2020 CNBC report, the average correction for the S&P 500 only lasted four months and the values fell by around 13% before recovering. However, it is easy to understand why the individual or novice investor may worry about a downward adjustment of 10% or more in the value of their portfolio assets during a correction. They have not seen it coming and do not know how long the correction will take. For most investors, in the long term market, a correction is just a pothole on the way to retirement savings. The market will eventually recover, so they shouldn’t panic.
Of course, a dramatic correction that occurs during a trading session can be disastrous for a broker or day trader and traders who are extremely in debt. These traders could see significant losses during periods of corrections.
No one can determine when a correction will start, end, or say how drastic a price drop will be until it is finished. What analysts and investors can do is examine the data from past corrections and plan accordingly.
Key points to remember
- A correction is a drop of 10% or more in the price of a security, asset or financial market.
- Corrections can last from several days to several months or more.
- While being damaging in the short term, a correction can be healthy, adjusting the prices of overvalued assets and offering buying opportunities.
Plot a correction
Corrections can sometimes be projected using market analysis and comparing one market index to another. Using this method, an analyst may discover that an underperforming index can be closely followed by a similar index which is also underperforming. A constant trend in these similarities may be a sign that a market correction is imminent.
Technical analysis examines levels of price support and resistance to help predict when a reversal or consolidation can turn into a correction. Technical corrections occur when an asset or the entire market is inflated. Analysts use charts to track changes over time in an asset, index or market. Some of the tools they use include the use of Bollinger Bands, envelope channels and trend lines to determine where to expect price support and resistance.
Prepare investments for a correction
Before a market correction, individual stocks can be strong or even outperforming. During a correction period, individual assets often perform poorly due to unfavorable market conditions. Corrections can create an ideal time to buy valuable assets at reduced prices. However, investors still need to weigh the risks associated with purchases as they may well see a further decline as the correction continues.
Protecting investments from corrections can be difficult, but achievable. To deal with falling stock prices, investors can set stop-loss or stop-limit orders. The first is automatically triggered when a price reaches a level predefined by the investor. However, the transaction may not be executed at this price level if prices fall rapidly. The second stop order defines both a specified target price and an external limit price for the transaction. The stop-loss guarantees execution when the stop-limit guarantees the price. Stop orders should be monitored regularly to ensure that they reflect the current market situation and the true value of the assets. In addition, many brokers allow stop orders to expire after a certain period.
Invest during a correction
While a fix can affect all actions, it often hits some actions harder than others. Small cap, high growth stocks in volatile industries like technology tend to react the strongest. Other sectors are more buffered. Consumer stocks, for example, tend to be tested by economic cycles, as they involve the production or retail sale of basic necessities. So, if a correction is caused by, or worsens, an economic slowdown, these actions continue to work.
Diversification also offers protection – if it involves assets that work unlike those that are corrected or that are influenced by different factors. Bonds and income vehicles have traditionally been a counterweight to stocks, for example. Real or tangible assets, like commodities or real estate, are another option for financial assets like stocks.
While market corrections can be difficult and a 10% drop can significantly harm many investment portfolios, corrections are sometimes considered to be healthy for the market and for investors. For the market, corrections can help readjust and recalibrate asset valuations that may have become too high. For investors, corrections can provide both the opportunity to take advantage of discounted asset prices as well as learn valuable lessons about how quickly market environments can change.
Creates buying opportunities in high value stocks
Can be mitigated by stop-loss / limit orders
Soothes over-inflated markets
May lead to panic, oversold
Harms short-term investors and leveraged traders
May turn into prolonged decline
Concrete examples of correction
Market corrections happen relatively often. Between 1980 and 2020, the American markets experienced 37 corrections. Meanwhile, the S&P 500 fell an average of 15.6%. Ten of these corrections resulted in bear markets, which are generally indicators of an economic slowdown. The rest stayed or returned to bull markets, which are generally indicators of economic growth and stability.
Take the year 2020, for example. In February 2020, two major indices, the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500) index, both underwent corrections, falling by more than 10%. The Nasdaq and the S&P 500 also underwent corrections at the end of October 2020.
Each time, the markets rebounded. Then, another correction occurred on December 17, 2020, and the DJIA and the S&P 500 fell more than 10% – the S&P 500 fell 15% from its historic high. The declines continued in early January, according to forecasts that the United States would eventually end a heavy bear market.
Markets started to recover, wiping out all of the year’s losses in late January. As of mid-April 2019, the S&P 500 has been up about 20% since the dark days of December. Optimistic analysts say the bull market still has legs to run, though some pessimists fear the recovery will be a short-term bear market rally – or to use another animal metaphor, a dead cat bounce.