What is a Stock Market Correction?

What is a stock market correction?

Dear Mr. Market:

Today we’re going to talk all about you and how you whipsaw investors into panic with stock market corrections. What exactly is a correction anyway?

To some this sounds like a simple question; to others, and judging on how they act with their investing decisions, it’s clearly not.

By definition a bear market is one that has stock prices falling by 20% or more and lasts for at least two months. A stock market correction is much shorter and is typically fast in nature. Corrections often come on the heels of investor pessimism or after a bearish story that later is found to be a relatively meaningless event. In other words, corrections bring a whole different sort of emotion to the game than a bear market.

What’s interesting to know about corrections is that they occur far more frequently than you might imagine.

The following chart gives an interesting visual of the frequency and magnitude of market drawdowns for the S&P 500 since 1950:

Click here

Going back 60 years the stock market has had 11 years where intra-year declines were 20% or more! Our friend Mr. Market once again tempts people at certain inflection points and then can punish or reward them with very little notice.

Going back even further you may be surprised to learn just how common market corrections are. They are a part of investing and ironically enough they are a needed occurrence in order for a healthy bull market to continue. Here’s a look at past market declines to put things in better perspective:

Frequency and Magnitude of Past Market Corrections

Take a closer look at the numbers above and specifically with regard to the last and previous occurrences. What does this tell you?

As the saying goes…”things always look more clear in the rear view mirror than through the windshield” but in this case these numbers point to something quite obvious. In our opinion, this market is clearly on borrowed time for a correction.

The challenge of a market that has been running so strong on relatively mundane economic news is that it tempts investors to “chase the heat”. Many hedge funds are in a pickle this year as well since they don’t trust this market but also can’t risk letting returns run away from them. The average hedge fund is actually trailing the S&P 500 by over 10% right now.  What to do?

Nothing. Yes…that’s what we just said… Don’t pretend your crystal ball works and you can predict a market correction. If someone, even a professional or “expert” is showing you their magical tea leaves…please tell them to take a hike as well. Corrections are often so sudden and sharp that they fool best of us. By the time anyone really has figured out what happened it’s over.

The bottom line is that “by not doing anything you actually ARE still doing something”! This is counterintuitive and it simply doesn’t “feel” right to not make a move. The majority of people who sell investments to avoid the downside of a correction typically do so at relative lows and once they decide it’s “safer” to get back in it’s typically at higher prices. What’s achieved in situations like this is transaction costs and training your brain to be even more fearful on the next go-around.

Making thoughtful and disciplined asset allocation adjustments in light of market movements is different. We can address the differences and specific approaches to that situation in future articles but for now…don’t let emotions or stock market gyrations dictate your strategy.

History will at least tell us that two things are clear:

(1) Nobody can consistently predict a correction or when to get in or out of the market. – If you’re fortunate (lucky) enough to get out of the market before it declines you need to have the same luck twice. Additionally, the majority of “experts” are always wrong when it comes to their annual stock market predictions.

(2) Nobody knows how long a correction (or bear market) will last. – Recent history points to market corrections being shorter than they used to be. Black Monday, and stock market crash in 1987 was brutal. The Dow Jones lost 22.6% in one day alone! What few people know or remember, however, is that the year actually finished positive. Although we don’t consider the Dow Jones as a relevant index to follow, imagine if we saw another decline of 1987’s magnitude? As of today’s close of 15,070 it would equate to a 3,405 point drop and the Dow Jones would be at 11,664.

Why even bring this up? Well…it’s actually happening right now! Maybe not to our domestic markets but if you haven’t paid attention Japan and the Nikkei Stock Average…here is a case in point. On Thursday, June 13, 2013, the Nikkei dropped another -6.4% in one day. This put the Japanese index down -21.9% from where it was just as of May 23!

Who knows where the market is headed? Lastly…guess what? A well constructed, disciplined, and properly managed portfolio doesn’t really care to predict corrections either. Do yourself a favor and don’t try to predict anything. You’ll miss most opportunities each time (up or down) and at the end of the day…emotional moves on market directions is not a strategy.

One thought on “What is a Stock Market Correction?

  1. Pingback: Is this the much anticipated market correction? Is the sky falling? | Dear Mr. Market:

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