Everything that goes up, has to come down at some point.
This includes the stock market as well, regardless of the region. Stocks, or equities in general are risky asset in general. Therefore, investors in general expect to see higher returns, adjusted for risk.
But every now and then, the stock market makes a correction, which gets the world talking. Depending on which financial media you follow, this can be from a mere mention to doom and gloom.
Afterall, a stock market correction is a headline grabbing event. Every so often, there will be a few who are eternal bears of the stock market. Thus, while constantly being negative on the stock market, they do end up being right, perhaps a few times in a decade.
The term stock market correction can be viewed as both good and bad. So, what are stock market corrections, why do they happen?
More importantly, should you be worried about a stock market correction? When a market correction happens, should you pull out all your investments?
This article on stock market corrections aims to answer these questions.
What is a stock market correction?
A stock market correction or a pullback is exactly that, as the names suggest. Price of the index tends to make a high before retreating.
A stock market correction, or a market correction happens when the stock index falls by 10% or more from its peak.
When this happens, the term market correction is used.
For example, if the U.S. S&P500 index hit a new all-time high of 4000 and later fell to 3600, that is a 10% decline. Investors call this a market correction.
A market correction is in essence, a regular phenomenon. If the stock index continues to rise steadily, it can leave out many buyers. Afterall, there is a saying in the markets about buying the dip.
Thus, a market correction gives the opportunities for new buyers to enter the fray. One can perhaps sum this up by quoting Warren Buffett, who famously said “Be fearful when others are greedy and buy when others are fearful.”
While this may sound like a good quote to perhaps stick on as a fridge magnet, in reality it is hard to implement. Afterall, when all the news you hear around you is about how bad the correction can be, you may succumb to this peer pressure.
Thus, like most, a stock market correction will lead you to remain on the sidelines, while some smart money is able to get in cheap.
How does a market correction look like?
To better understand how the market correction looks like, see the chart below.
We have the S&P500 chart with areas highlighted that show a significant correction. These corrections, marked with the red down arrow show a 10% or more decline.
As you can see from the below S&P500 chart, there were just two instances of a 10% decline.
The first occurred during the start of the Covid-19 pandemic around March 2020. This led to a near 36% decline in the S&P500.
Following this, the next stock market correction happened in September 2020, barely a few months after markets recovered.
This time, the S&P500 corrected close to 11% before recovering.
In the same chart, there are other smaller corrections. These corrections were “in-between.” Read as, greater than 5% but less than 10%.
Such smaller corrections happen more frequently than the official “market correction.”
By eyeballing the chart, one thing is obvious. Market corrections are common phenomenon. So why make a big fuss out of this?
When it comes to market correction, it’s a game of chicken and egg!
The markets are merely a reflect of investor sentiment. Therefore, there is nothing magical or mysterious about such corrections.
The market correction, of the index, merely reflects the broader investor sentiment. The corrections occur when something sets off in the market. This could be many reasons. From political or policy uncertainty to risks.
A market correction can set off a bear market
One thing to remember during market correction is that it can quickly morph into a bear market.
A bear market is defined as when the index prices fall by 20% or more
Thus, by connecting the dots, one can see why a mere 10% or even a 5% correction in the markets gets everyone talking.
Since no one can predict a market correction or a move from bull to bear market, a correction gives us the first glimpse of what could come.
If you look back at the above chart, we have seen instances of a correction up to 5%, but less than 10%. But following this, the markets have managed to correct themselves. But in the same note, a 5% – 10% correction also happened in March 2020.
This was before the S&P500 officially moved into a bear market territory.
Thus, when such correction happens, investors tend to over-think. Could this 5% correction morph into a 10% correction? Could this then lead to a further decline?
As you can see, one thing leads to another and as a result, the general public can start panicking.
Statistically, studies have shown that there was a total of 24 market corrections since 1974. And from these 24, only five morphed into a full-fledged bear market.
Yet, these corrections of 5% and 10% become good talking points. Afterall, who doesn’t want to get the bragging rights of predicting a bear market?
What can you do during a market correction?
The answer to this can depend on how you invested in the first place.
For the sake of simplicity, assume that you invested in an index fund that tracks the S&P500. A market correction won’t happen, until it happens. While there are many naysayers, the truth is that no one can predict a correction.
Thus, the best way to protect your investments is to regularly cash out. At the same time, corrections can provide you with an opportunity to reinvest. This is referred to as buying the dip.
From complex quantitative methods to simply analyzing the markets, one can draw up many complex and simple ways.
But at the end, it is the investor who needs to figure out what they should do.
For example, if you were unlucky enough to buy at the peak, then even a 3% correction could be disastrous.
Thus, one of the key things to investing, especially in an index is to buy the dips.
This is where the market corrections can prove to be valuable. You are in essence buying at a discount rather than at a premium.
But there needs to be a balance. For example, if you had purchased the S&P500 at a 10% correction in March 2020, then that would turn into a bad investment.
Given that the markets fell 35%, this buy the dip strategy would be a bad choice.
On the other hand, if you had bought into the dip in November 2020 and held it to date, that would return you close to 39%.
But of course, hindsight is 20/20. And it is easy to spot such opportunities in hindsight.
How to prepare during the market corrections?
As you know already, market corrections happen all the time. A market correction may or may not lead to a bear market.
Therefore, the key is in identifying whether the correction is an opportunity to buy into the market or to wait.
There are different ways to do this.
For one, if you look at this problem fundamentally, the landscape can become very confusing. Afterall, various research papers and experts tend to give their own justification.
But we do not dismiss the fundamental analysis completely. One should in fact checkout what is going on. This could mean, looking at various other things happening in the market.
A good example of the latest so called correction which happened in September 2021 can be attributed to factors such as the Evergrande debt crisis.
This led to the S&P500 falling close to 2%, 3% and 3.5% respectively in a span of just under a month.
Typical market corrections are offset by such news. Panic and uncertainty are two things’ investors do not like. As the saying goes, investors tend to sell first and ask questions later during uncertainty.
This couldn’t be further from the truth when looking at the above example.
Thus, we can reiterate the fact that when it comes to market correction, investors should keep their ears close to the ground. But at the same time, look at it objectively.
Markets can get themselves into a hype mode. Going back to the Evergrande crisis, at one point, various media channels started calling it China’s Lehman moment. Of course, this term started to fade away as the Chinese authorities made it clear that they were in control.
In contrast, the actual Lehman moment in the U.S. caught the markets by surprise.
You can start to get the picture now of why market corrections tend to happen.
Can technical analysis help with market correction?
When you are looking for timing, technical analysis can be a great tool.
Many investors are often dismissive of technical analysis. Yet, when you combine the knowledge of the fundamentals with the technical, it can provide great insights.
A simple way to look at market corrections is to observe the prices compared to their moving averages. A market correction is merely a return to the mean. This is a phenomenon that happens all the time.
Thus, technical indicators such as moving averages can be a great tool.
Besides these, you can also observe prices by looking at not just the candlestick charts, but also renko charts. These charts, which are quite unique and easy to distinguish can give you insights that you didn’t know existed.
Using technical indicators on renko charts, one can draw up various renko trading strategies to spot these corrections.
The question on whether or not to trade these dips is of course subject to a lot of other factors. These include the amount you want to invest, your holding period, and most importantly, understanding the context.
Conclusion – Market corrections can be your friend
In conclusion, market corrections are actually nothing to worry about. Of course, this depends on if you are already invested. More importantly, if you bought at the peak, then a market correction will certainly keep you up at nights.
On the other hand, if you are looking to invest in the markets, corrections provide a great entry point. These dips offer you the choice to buy the index at a discount.
If you are smart enough (and lucky) to buy at these turning points, the returns can be significantly greater.
The concept of market corrections is something fascinating. While they do not occur all the time, when they do, corrections can be a great way to ride the stock market wave.