Everything you need to know about stock market corrections

Stock market corrections are a natural part of the market cycle, but they can seem daunting for new traders and investors. Discover everything you need to know about stock market corrections – including what they are, what percentage decline constitutes a correction and how often they occur.

Stock market trader
Source: Bloomberg

What is a stock market correction?

A stock market correction is a 10% decline in the price of an individual stock or index from its 52-week high.

The stock market is always rising and falling, which means that sometimes share prices will experience gains even if the company’s book value hasn’t changed. These fluctuations are largely due to the psychology of investors and speculators, who anticipate that the stock or index will help them turn a profit, even if revenues or sales don’t back up the valuation. And as more and more people jump on the bandwagon, the price is inflated.

Once a certain price is reached, the stock or index starts to become considered overvalued. At this point, an event will occur that causes the trend to reverse and market participants will start to close their positions to realise any gains. This causes the price to decrease and reach a more stable price – at this point, the market is said to have ‘corrected’ itself.

Market corrections usually take into account a stock or index’s true value. It is not necessarily that the company is losing value in the real world, so much as the share price is correcting to reflect the stock’s actual value on paper.

What causes a stock market correction?

There are several factors that can trigger a stock market correction, ranging from below-expected company earnings reports to a turbulent political climate. It is quite difficult to predict the timing of a market correction, but analysts will often look at historical averages and similarly performing assets to form an opinion.

How often do stock market corrections occur?

Even though stock markets generally rise over the long term, market corrections occur relatively often – it is never really a question of whether a stock market correction will occur, but rather when it will happen and how large it will be.

Many market analysts tend to expect one correction every two years or less. They can last for varying amounts of time, either days, weeks or months. But it is impossible to know with any certainty when the correction will start or end.

Stock market correction history

To make things easier, we are going to be focusing on the history of S&P 500 corrections because it is considered a global benchmark of stock market performance. The stock market corrections chart below shows the history of S&P 500 corrections of 10% or more during the past 20 years.1

When was the last stock market correction?

Depending on the stock exchange that you are examining, the most recent stock market correction may differ. If we continue looking at the S&P 500, the last stock market correction is slightly subjective. The definition of a stock market correction does state that the market has to decline by 10% from its 52-week high, but a lot of people will talk about the stock market correcting before this threshold has been reached. For example, in November 2018, the S&P 500 was said to be in a correction even though it had only fallen by around 6%. It was also thought to have been in the process of correcting the month before, in October 2018, but the decline was just over 9%.

The most recent stock market correction that everyone can agree on occurred in February 2018, when both the Dow Jones and the S&P 500 experienced a correction. Their values declined by 10.4% and 10.2% respectively, following a peak in late January.

Correction vs bear market

The major difference between a market correction and bear market is the extent to which the prices fall. In a market correction, the price needs to have fallen by around 10% from its 52-week high, whereas bear markets can see stock prices drop by 20% or more. On average market corrections tend to last less than two months, while bear markets can last much longer.

The last significant bear market was during the 2008 financial crisis, when the S&P 500 dropped by more than 56% and lasted for 517 days.

Bear markets should not be confused with a stock market crash, which is an extreme and sudden drop in share prices. It is worth noting that market crashes have been known to lead to longer periods of market decline, or bear markets.

Who does a market correction impact?

Market corrections tend to only impact short-term investors and traders. Long-term investments are likely to be held for such a long time that they will be unaffected by short-term corrections, but it is important that the investor does not panic during the sell-off. In order to establish what the correct action to take is, an investor should remain focused on their strategy and goals, knowing when to sell and when to remain in the market.

For traders, the unpredictability of market corrections is just one reason that it is important to implement a suitable risk management strategy. Attaching stop losses to any position is a crucial part of trading any financial market and preparing for market volatility.

1Yardeni Research, 2018

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