“A correction is a decline of 8 to 12% or more in the price of a security, asset, or a financial market”— Paul Ebeling
Corrections can last anywhere from days to months, or longer. While painful in the short term, a correction is healthy, adjusting overvalued asset prices and providing buying opportunities.
A dramatic correction that occurs in the course of one trading session can be painful for a short-term or day trader and those traders who are extremely leveraged. These traders could see significant losses during times of corrections
No one can pinpoint when a correction will start, end, or tell how drastic of a drop prices will take until after it is finished. What analysts and investors can do is look at the data of past corrections and plan accordingly.
Corrections can be projected using market analysis, and by comparing one market index to another. Using this method an analyst may discover that an underperforming index may be followed closely by a similar index that is also underperforming. A steady trend of these similarities may be a sign that a market correction is imminent.
Technical analysis review price support and resistance levels to help predict when a reversal or consolidation may turn into a correction. Technical corrections happen when an asset or the entire market gets overinflated.
Analysts use charting to track the changes over time in an asset, index, or market. Some of the tools they use include the use of Bollinger Bands, envelope channels, and trendlines to determine where to expect price support and resistance.
Before a market correction, individual stocks may be strong or even overperforming. During a correction period, individual assets frequently perform poorly due to adverse market conditions. Corrections can create an ideal time to buy high-value assets at discounted prices. However, investors must still weigh the risks involved with purchases, as they could well see a further decline as the correction continues.
Protecting investments against corrections can be difficult, but doable. To deal with declining equity prices, investors can set stop-loss orders or stop-limit orders. The former is automatically triggered when a price hits a level pre-set by the investor. However, the transaction may not get executed at that price level if prices are falling fast.
The 2nd stop order sets both a specified target price and an outside limit price for the trade. Stop-loss guarantees execution where stop-limit guarantees price. Stop orders should be regularly monitored, to ensure they reflect current market situations and true asset values. Also, many brokers will allow stop orders to expire after a period.
While a correction can affect all equities, it often hits some equities harder than others. Smaller-cap, high-growth stocks in volatile sectors, like technology, tend to react the strongest. Other sectors are more buffered. Consumer staples stocks, for example, tend to be business cycle-proof, as they involve the production or retailing of necessities. So if a correction is caused by, or deepens into, an economic downturn, these stocks still perform.
Diversification also offers protection—if it involves assets that perform in opposition to those being corrected, or those that are influenced by different factors. Bonds and income-vehicles have traditionally been a counterweight to equities, for example. Real or tangible assets, like commodities or real estate, are another option to financial assets like stocks.
Although market corrections can be challenging, and a 10% drop may significantly hurt many investment portfolios, corrections are sometimes considered healthy for both the market and for investors. For the market, corrections can help to readjust and recalibrate asset valuations that may have become unsustainably high. For investors, corrections can provide both the opportunity to take advantage of discounted asset prices as well as to learn valuable lessons on how rapidly market environments can change.
- Creates buying opportunities into high-value stocks
- Can be mitigated by stop-loss/limit orders
- Calms over-inflated markets
- Can lead to panic, overselling
- Harms short-term investors, leveraged traders
- Can turn into prolonged decline
Market corrections occur relatively often. Between Ys 1980 and 2018, the US markets experienced 37 corrections. During this frame the S&P 500 fell an average of 15.6%. And 10 of these corrections resulted in Bear markets, which are generally indicators of economic downturns. The others remained or transitioned back into Bull markets, which are usually indicators of economic growth and stability.
We are in a Bull market.
The underlying fundamentals are very positive for this stock market. But, because the stock market has been steadily climbing a wall of worry, a big dose of negativity could produce a pause to refresh. So, having some buying power handy is a good strategy.
Have a happy healthy weekend, Keep the Faith!