The main difference between the big money makers in the stock market and the rest is knowing how to read and understand the different phases or trends. That is where all the money is, and that is why some of us trust them with our funds.
For instance, you might have been hearing of “market correction” about the stock market, but what really is it, and how is it essential to your investment strategy?
Sometimes it appears we might be in for a stock market correction which is not a surprise. Once there is an uptrend, a stock market correction is always around the corner. As an investor, you should know what to do when you expect a bumpy situation in the market.
Unfortunately, it is almost impossible to predict the market; neither will the market ever give advance notice if there’s going to be a bear market or if what’s coming is barely a correction. So it is vital to know what a market correction is and how to identify one.
What is a Correction
The stock market correction is also known as a pullback. It’s a pause or a moderate drop in stocks or commodities pricing chart from a recent high that happened during a current uptrend.
It’s called a correction when there’s a decline of 10% in the stock market from a 52-week high price.
A stock market correction is a natural occurrence that happens all the time. A correction is similar to a retraction or consolidation, and it has been happening in the past 40 years.
Seasoned investors always welcome a correction because it could signal that the market is consolidating before it hits new highs.
A correction in the market is usually a short-term drop in prices. For example, you will notice a restriction from an uptrend for a few consecutive sessions before the resumption of the bullish market for new highs.
How Correction Works
No one can say when a correction will occur or precisely how long it will last, or how drastic the fall will be until it is over. The best experts can do look at the historical data of previous corrections and plan accordingly.
A stock market correction can be likened to a spider under your bed, you are aware of its presence there, but you have no clue when it appears again. You may lose sleep over the appearance of the spider, but you don’t have to do the same for a stock market correction.
According to a 2018 CNBC report, the average correction for the S&P lasted only four months, with drops in values around 13% before staging a recovery. Having a 10% or more decline in the value of your portfolio during a correction is a disturbing state to be in, especially if you are a new investor.
However, for investors who have been around for a while and in the market for the long term, a correction is a temporary setback on the way to the larger picture. The market is expected to recover and head higher.
It is also important to note that a dramatic correction during a trading session might be disastrous for day and short-term traders. The highly leveraged traders would experience significant losses that can completely take them out of the market during a correction.
The State of The Market Today
To fully understand if it is better to invest now or wait for the correction in the market to happen, you need first to understand the state of the stock market. Then your decision will be easier.
On The Average, A Correction Occurs Every 1.87 Years
Let’s start with what we know. Correction occurs in the stock market more than you probably know.
According to recent research by market analytics firm Yardeni, the S&P has undergone 30 corrections since 1950. That’s an average of one 10% decline every 1.87 years.
Having said that, the stock market doesn’t just follow norms. For example, there was no known correction in the S&P greater than 10% between 1991 and 1996. Meanwhile, since 2010 we have seen seven double-digits percentage declines in the same S&P.
While it may be impossible to predict precisely when a correction will occur, you may not be too far off if you believe one is around the corner.
Weakening Bull Market
Analysts predict that we might have entered the worst six-month period for stock known as the “Sell in May” period. In the meantime, the current bullish trend in the S&P is nearly tracking the 2009/2010 bull market.
If the current trend continues to follow the 2009/2010 bull market pattern, we might be heading for a 16% correction.
While we might not see precisely a 16% correction this time around, it is clear that after an 80% move in just over 12 months, realistically, you should expect some form of volatility in the form of a correction soon.
Contrarian Sell Signal Initiated by Strong Economic Data
A Contrarian investment style is a strategy where investors take positions against the prevailing market trend. That is, they go bullish when the market is bearish and bearish when the trend is bullish.
With the economy kicking back from the Covid-19 pandemic, it appears the peak in business activity could present a contrarian sell signal.
Manufacturing PMI hit its highest level since 1983, while Services PMI data equally hit an all-time high. However, like in the past, when such highs were hit, the bullish market stalled out. We could be seeing the same thing this time around over the following three to six months with flat or adverse reactions from the market.
Stocks are priced at Near Perfection.
The stock market is already at a record high while the economy continues to recover from the pandemic lockdowns. The forward price to earnings ratio of the S&P 500 is currently at its highest level since the 1990s, just before the dot-com bubble.
The price of stocks is as pricey as today doesn’t mean a bear market is imminent. Still, it indeed does send a warning signal that any negative economic or Covid-19 related data could lead to increased volatility and a correction.
Does Market Correction Always Lead to a Crash?
New investors are quick to ask or enter a panic mood whenever a correction is imminent, but not every correction is the beginning of a bear market.
A market crash is when the prices of stocks drop more than 10% in a single day.
Stock market crashes often lead to a bearish trend. A bearish market is when the market experiences another 10% drop making a 20% fall in stock prices in a single session.
A crash in the stock market leads to a recession, which is very different from what happens when the market is in a correction.
For better understanding, the sale of stocks is where companies get the money they use to fund their businesses. The lower the stock prices, the lesser the chances of the company growing, and if the company is not growing, it will need to lay off some of its staff to stay in business.
As the employees are laid off, their spending power reduces. This further leads to reduced demands, and lower revenue, and more layoffs. If this trend continues, it takes its toll on the economy, and a recession happens.
Invest Now or Wait for the Correction
During a correction, individual assets start to perform poorly, or prices begin to fall due to unfavorable economic conditions. Also, a correction can create an ideal time to enter the market again and buy high-valued stocks at discounted prices.
However, investors must weigh the risk involved with such buy positions because the market could be heading for a further decline as the correction continues.
The question is, how do you protect your investment against losses during a correction? It is difficult but possible. Seasoned investors have learned to set Stop-loss orders or stop-limit orders to avoid taking too much loss. It is an instruction where you asked the trader or trading system to stop and close your trades when prices fall below certain levels.
It can be pretty stressful trying to anticipate a correction. You need to resist the urge to time the market. You will find some day traders who make money here and there using strategies like swing trading, but it rarely works when building a long-term wealth plan.
Diversification Will Protect You
A stock market correction affects all equities, but it hits some equities harder. Small-cap, high-growth stocks in volatile sectors like technology react the strongest while other sectors are more cushioned.
For example, consumer stock is usually business cycle proof because they are involved in producing or retailing necessities. So if a correction deepens into a bearish market and later a recession, these stocks will still perform.
Diversification offers protection over a correction because it involves assets that perform against those going through a market correction. Bonds and income vehicles usually counterweight equities.
For instance, Like commodities, real estate, or real and tangible assets are other options for financial assets like stock. In essence, mix your portfolio up in a way that you will not have to face the same experience from your entire investment. There should be shock absorbers.
Suppose you must invest in the stock market. In that case, it is best to understand that correction is a natural and regular occurrence in the market, and it’s best to ride them out. If possible, avoid the temptation to trade and profit from a correction.
Follow the old Wall Street warning – Never catch a falling knife.