Stock Market Correction

When Stock Prices Fall, How Can You Tell If It's a Correction or a Crash?

stock-trader-upset.jpg
Barclays Capital trader Mario Picone holds his head while working on the trading floor at the New York Stock Exchange on September 9, 2011 in New York City. Photo by Justin Sullivan/Getty Images

Definition: A stock market correction is when the market falls 10 percent from its 52-week high. Wise investors welcome it. A pullback allows the market to consolidate before going toward higher highs. Each of the bull markets in the last 40 years has had a correction. It's a natural part of the market cycle. Corrections can occur in any asset class. 

What causes a correction? Typically, it's an event that creates panicked selling.

It can be a gut-wrenching time. Many beginning investors will feel like joining the mad dash to the exits. That's exactly the wrong thing to do. Why? The stock market usually makes up the losses in three months or so. If you sell during the correction, you will probably not buy in time to make up your losses.

Corrections are inevitable. When the stock market is going up, investors want to get in on the potential profits. It leads to irrational exuberance. That makes stock prices go well above their underlying value. A correction is when prices return to that reality-based level.

Correction Vs. Crash

A correction becomes a stock market crash if the 10 percent price drop occurs in just one day. Crashes easily lead to a bear market. That's when the market falls another 10 percent, for a total decline of 20 percent or more.

Unlike a correction, a stock market crash can cause a recession. How? Stocks are how corporations get cash to grow their businesses.

If stock prices fall dramatically, corporations have less ability to grow. Firms that don't grow will eventually lay off workers to stay solvent. As workers are laid off, they spend less. Lower demand means lower revenue. That means more layoffs. As the decline continues, the economy contracts, creating a recession.

How to Protect Yourself

It's difficult to predict a crash because it happens so fast. Trying to decide if a correction is turning into a crash is known as timing the market. It's nearly impossible to do. There are too many factors that can influence the direction the market goes in.

The best strategy is to have a diversified portfolio. That means holding a balanced mix of stocks, bonds, and commodities. The exact mix depends on your personal financial goals. The stocks will make sure you profit from market upswings. The bonds and commodities protect you from market corrections and crashes. With diversification, you will feel safe to ride out any stock market corrections.

History

The stock market typically has a correction several times a year.  For example, between 1983 and 2011, more than half of all quarters had a correction. That averages out to 2.27 per year. Fewer than 20% of all quarters experienced a bear market. That averages out to .72 times per year. (Source: "How Often Does the S&P Have Negative 10 Percent and 20 Percent Price Moves?

" QVM Group LLC, March 19, 2013.)

Stock corrections are more frequent than crashes because they occur when the economy is still in the expansion phase. Why would the market correct even when economic data is upbeat? The stock market is a leading economic indicator. Investors look at future expected earnings to forecast corporate profits. They buy or sell stocks based on these projections. Sometimes investors become too optimistic. They create a rally that exceeds current economic performance. That's when the market gets over-extended. Once that happens, any bit of doubtful news causes a correction.

As long as the future trend remains optimistic, the buying will resume. That leads to an even stronger bull market rally. In other words, a stock market correction can help the stock market catch its breath and hit even higher peaks. 

The history of the Dow reveals that most recessions occur with stock market declines of 30 percent or more. That's the contraction and trough phase of the business cycle. A crash can create them, but usually larger economic events are the underlying cause. That's what makes a crash more devastating than a correction.

Continue Reading...