Macro Mondays: Correction
Welcome to another edition of Macro Mondays! We always worry about what big dips in the stock market mean, but more often than not the dips are healthy and should provide more opportunities for gains than long-term harm. That is way today I want to address the notion of 'corrections,' which make their way into news headlines without much explanation of what they imply long-term for investors.
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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. 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.
How do we know if we are in a '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 as a whole does not necessarily tell how any one stock is performing. A stock may remain strong despite a correction.
For example, consumer staples tend to perform steadily in any market. 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.
how frequently do markets enter corrections?
Market corrections in the stock market are fairly frequent events. Over the long-term, a 10% pullback in stock prices occurs about once a year. Prior to the market correction during the second half of 2015, the stock market had gone nearly three years without a correction. They 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.
are corrections actually healthy for the market?
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.