A popular idiom is “what goes up must come down”. Although this phrase is typically associated with gravity it can also apply to investing. Individual securities, and indeed even entire asset classes, rise and fall. And while Newton’s laws of motion don’t apply to the market, there is some science involved. Psychology plays a role in investing, and when a surging market reaches a new high, it’s not uncommon for the market to swing lower, sometimes by a little – and sometimes by quite a bit more.
When an index or security drops below a certain point off a recent high, investors will hear that it is correcting. This can be a cause anxiety for novice investors, and even experienced investors whose portfolio does not display proper asset allocation. However corrections can be a great buying opportunity for investors who have the money, and the nerve, to invest.
In this article, we’ll define a correction and why corrections occur. Well also review the important features of all corrections and look at steps that investors can take if they are concerned about exposing their portfolio to a correction.
What is a correction?
In investing terms, a correction is defined as a statistical event where the price of a security or asset class experiences a decline of at least 10% (although it could be more) from its most recent peak. Corrections can happen quickly (i.e. a correction can occur over a period of a few days) or it can last a few weeks or even months.
As recently as October of 2018 the NASDAQ Index and the S&P 500 Index experienced a correction. Before that, in February of 2018, the Dow Jones Industrial Index and the S&P 500 also went into a correction. This brings up an important point about corrections. For a correction to occur, the underlying security or asset class has to be going through an upturn. This is also why corrections can cause anxiety for investors, particularly short-term traders whose profits can be affected by rapid price movements.
Why do corrections happen?
At their core, corrections are caused by investor psychology, which can lead to stock being overvalued. When an investor sees a stock rise from $65 to $75, they might feel hesitant to invest in the stock thinking that it has already reached its peak. However, the company posts a solid earnings report, industry analysts rate the stock as a buy and the stock continues to rise to $85 per share. This rise from $75 to $85 is when a lot of retail investors jump in while, at the same time, institutional investors begin to slow down on their purchases. When the stock reaches $85, the stock forms what’s called a “top”. At this point, institutional investors usually perceive the stock as being overvalued and begin to take profits. This selling activity then starts to gain momentum and the stock continues to decline until it finds a “floor” perhaps around $75.
Did this mean the company’s earnings report was inaccurate? Or that the analysts were wrong in listing the stock as a buy? Not necessarily, the long-term fundamentals for the stock may be strong and the move up to $85 gave investors an opportunity to take short-term profits. If the stock is still supported by strong fundamentals, it may continue to climb, but at a more measured pace.
What are defining characteristics of a correction?
It’s human nature to want to know what’s going to happen. It creates the illusion that events can be controlled. And if there’s one thing investors desire it’s the ability to control events. However, no two corrections are identical. Nevertheless, analysts have found that corrections share some common characteristics that can help give investors peace of mind.
- They happen frequently– There have been 36 corrections in the stock market between 1980-2018. That averages to virtually one correction every year. And, as pointed out earlier, there were two in 2018 alone – and both of those were during a bull market. The takeaway for investors is that they should turn the idiom around and realize that what goes down will also come back up.
- Corrections rarely last long– Of the 36 corrections that the market has recorded since 1980, ten did precede a bear market. However, that means that 26 could be considered pauses in bull markets. Frequently, investors will confuse a correction with a bear market, but they are actually separate events with different measurements.
- Corrections can be hard to predict– This can be one of the more unsettling characteristics of a correction for investors, but most corrections don't follow a pattern. That's because there's a psychology that exists in a correction, and investor psychology does not always follow rational patterns and can be influenced by news headlines and geopolitical events.
- Corrections, in theory, should not matter to long-term investors– For investors who are committed to a long-term investment strategy, a correction should not be a source of concern. In fact, if they make regular contributions to their portfolio through vehicles like an employer-sponsored 401(k), they can benefit from dollar-cost averaging and use corrections as an opportunity to buy stocks that are on sale. Short-term traders, on the other hand, can be affected by a correction unless they have impeccable market timing – which rarely happens.
- Corrections can be a good buying opportunity– A correction does not necessarily mean that a stock is a poor investment. In some cases, a correction simply means a stock has become overvalued and investors are taking the opportunity to take profits. Long-term investors can use this opportunity to buy securities when they’re “on sale”, which over time can allow them to experience significant capital gains in their portfolio.
- Corrections are a chance to practice asset allocation– Every investor should periodically look at their portfolio and see if their investment mix still makes sense. After all, “buy and hold” doesn’t mean “buy and forget”. For example, when a particular stock drops by 10% or more, it’s a good time for investors to ask if the reasons they purchased the stock initially still apply. In some cases, a correction may be an initial indicator that something has changed with a particular stock or sector.
What are strategies to protect a portfolio from a correction?
Many investors realize that corrections are a natural part of an investing cycle. As unpredictable as they may be, a correction is not something that most investors should fear. Nevertheless, depending on their risk tolerance, investors may want to actively protect their portfolio from a correction. Here are some strategies that can help investors protect their portfolio from a correction.
- Rebalance your portfolio– Before a security corrects, it will reach a new high. Paying attention to assets that are rising faster than others may show an investor that a desired 60% stock/40% bond mix has been skewed to 69% stocks and 31% bonds. When this happens, investors can choose to take some profit from their stocks and reinvest them in bonds to bring their portfolio back into the right balance.
- Look for securities that have low volatility– During a correction, the most volatile assets can suffer the largest price decreases. Commodities are known for being very volatile; consider how the oil market moves. Gold and other precious metals have been very volatile. But even in stocks, there are sectors that are more volatile than others. By choosing to invest in stocks that are less volatile, an investor can reduce their risk. Of course, the tradeoff is that they reduce their potential gain as well.
- Buy defensive stocks – This is similar to low volatility stocks. Defensive stocks are stocks that tend to perform well regardless of the state of the economy. This also gives these stocks less exposure to a correction. Amazon and Wal-Mart are considered defensive stocks because people will continue to buy from them during recessions. Investors can also look to sectors like health care and cellular phone providers for quality defensive stocks.
- Buy government bonds– When there is uncertainty in the market, investors can draw confidence that U.S. Government Bonds are backed by the “full faith and credit” of the U.S. government. Investing in bonds, particularly long-term bonds, exposes an investor to the risk of a declining yield when interest rates rise, but if you’re looking to add diversification to your portfolio, U.S. government bonds can be a good choice.
- Increase the cash in your portfolio – Although having too much cash on the sidelines can severely limit the growth of your portfolio when markets are red hot, having some cash readily available can be a huge advantage during a correction. Remember, securities correct for a variety of reasons, most of which are psychological. This means that sometimes bad things happen to good stocks. A correction, therefore, is an ideal opportunity to buy quality stocks at bargain prices.
Using technical analysis to spot a correction
Spotting a correction involves market timing, which is always an imperfect science. However, for day traders and other investors who rely on technical analysis to profit from the stock price movement, there are a few indicators that may signal a correction is ready to occur.
The stock is showing a break at key support levels – a support level is a technical indicator that shows the point where the number of buyers is greater than the number of sellers. On a stock chart, it is the peak right before a stock’s price goes down, which can be the precursor to a correction.
The moving average crosses over the trend line– no stock moves in the same direction all the time, but every stock typically shows a trend. One of the ways investors track the accuracy of a trend is through a stock’s moving average. When the moving average shows evidence that it is consistently crossing below the trend line, it can indicate a correction is ready to happen. There are a number of tools that technical indicators use including Bollinger bands and stochastic indicators to try to see a reversal in a stock’s trend line.
The bottom line on corrections
If you're going to be an investor, you have to be prepared for corrections. A correction is a statistical event that indicates a particular security or asset class has dropped at least 10% from a recent high. Corrections are usually a result of investor psychology where retail investors rush in to boost the price of a security at the same time that institutional investors may be pausing or even selling. The result is the security reaches a “top” and the correction begins. Corrections can last days, weeks, or months.
Although corrections can be unsettling, they have historically indicated a pause in a bull market instead of preceding a bear market. In 2018, during a historical bull market, the S&P 500 has undergone two corrections.
Corrections can be difficult to detect until one is already underway, however, they are usually short-lived and for that reason should not affect long-term investors. Corrections can also be ideal opportunities for investors to buy shares while they are at lower prices. Investors with a low-risk tolerance can apply a variety of strategies including shifting to less volatile and defensive stocks, or for the truly risk-averse, shifting more of their portfolio into cash.
Traders use a variety of strategies to time the market in an effort to spot a correction. By paying attention to breaks in support levels and watching changes in a security’s moving average, traders can capitalize on short-term price movement.