What is a ‘Correction’
A correction is a reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation. The latest stock market correction occurred on February 8, 2018 as the DJIA and the S&P 500 fell more than 10% from their recent highs hit in late January, 2018. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a bear market or a recession, but it can be a precursor to either. A correction is very different from a crash since it measures the the percentage decline from the most recent high. A crash is generally considered to be a 10% or more decline, irrespective of the most recent high.
BREAKING DOWN ‘Correction’
One way analysts attempt to predict whether a market is headed for a correction is to compare one market index to a similar index. For example, if the U.K.’s FTSE 100 has recently underperformed, the Standard & Poor’s (S&P) 500 in the United States might follow suit. When the market is showing a trend of closing lower, a correction may be at hand. However, a correction in the market or index as a whole does not necessarily tell how any one stock is performing. A stock within an index may remain strong despite a correction. A stock could also perform about the same as the overall market during a correction, or it could plummet even further than the overall market. A correction can be an opportunity for value investors to pick up good companies at bargain prices.
Frequency of Market Corrections
Market corrections in the stock market are fairly frequent events. On February 8, 2018, the DJIA and the S&P 500 both fell into a correction falling more than 10% from their highs on January 26, 2018. Prior to this most recent correction, we have experienced 36 corrections in U.S. markets since 1980, and the S&P 500 fell by an average of 15.6% from peak to trough during those periods. One year after that, on average, the S&P 500 returned 16% from the low. Two years after that, on average, the S&P 500 returned 28% from the low, according to LPL Financial. Only 10 of the 15 correction in the S&P 500 turned into Bear markets. Prior to the correction during the second half of 2015, the stock market had gone nearly three years without a correction. Corrections also tend to be relatively short-term phenomena. On average, a market correction lasts about three to four months. During the recent stock market dips in September 2015 and again in January 2016, in each case, the S&P 500 was able to retrace most of its gains within roughly two months of entering correction territory.
Corrections are Healthy for the Markets
Despite the inherently uncomfortable nature of watching an account balance drop by 10% or more, market corrections can be healthy for both the market and for investors.
The stock market is fairly volatile on a short-term basis but has a strong track record of success over the long-term. Many view corrections as an opportunity for the stock market and traders to digest recent gains and avoid a sense of irrational exuberance in the short-term. For investors, corrections provide a chance to see how truly comfortable they are with market risk, and to make changes to their portfolio if warranted. They also provide investors with an opportunity to potentially add companies at discounted prices, or to dollar cost average down on existing positions.