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Market Correction: Definition, Duration and Everything Else You Need to Know

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A market correction can be unsettling because you don't know if it may turn into a bear market.

When people talk about a market correction, it sounds like a euphemism for falling stock prices. But it’s actually a technical term for a 10% or bigger drop in the price of an index (or individual security) from the last peak. If index prices continue to sink to 20% off the peak, that’s considered a bear market — beyond a mere correction. To protect your investments during down times and amid all market conditions, consider working with a financial advisor.

What Is a Market Correction?

As mentioned above, a market correction is not just a positive way of describing negative market conditions. It technically refers to a 10% or bigger drop in prices from a recent peak. Often, corrections are reserved to describe small pullbacks while bear markets are used to describe big pullbacks (20% or more). But a bear market is, by definition, a correction though it’s more aptly called a major correction.

What Does a Market Correction Signify?

The concern about market corrections is that they can lead to bear markets. Indeed, from 1999 to 2019, two of 10 corrections did just that, according to Yardeni Research’s analysis of the Standard & Poor’s 500 index. And bear markets, in turn, may signal a recession, which is what happened in 2007.

That said, corrections that don’t deepen into bear markets only signify that stocks were overpriced. This is why the downward valuation is called a correction.

How Common Is a Market Correction?

With the S&P 500 seeing two corrections in 2018 (February and December), you might think that corrections are common. Or if you looked at the years 1991 to 1997, when there were no technical corrections, you might think they are infrequent. On average, corrections happen every 1.7 years and last 112 days, according to Wes Moss, chief investment strategist at Capital Investment Advisors.

If it surprises you to hear that corrections only happen roughly every other year, you probably watch a lot of financial cable news. As prices slide, business reporters start talking about heading into “correction territory.” Indeed, since the Great Recession, the S&P 500 has had seven dips that were 5.8% to 9.9% off the index’s peaks, on top of six actual corrections. That’s 13 news cycles of hearing about corrections in the past 10 years, while there have been only 22 real corrections in the past 45 years (since 1974), according to Charles Schwab & Co.

When Was the Last Market Correction?

As of July 2019, the last market correction was from mid-December 2018 to early January 2019, when both the Dow Jones Industrial Average and S&P 500 dropped more than 10%. By the end of January 2019, the indexes had rebounded and were up 7.2% and 7.9% respectively.

Earlier in February 2018, there was another correction when the DJIA fell 12% and the S&P 500 fell 10.6%. Within the past decade, there were also corrections in April 2010, April 2011, May 2015 and November 2015, according to Charles Schwab & Co.

Unfortunately, there's no foolproof way to predict the timing or magnitude of a market correction. How Do You Predict a Market Correction?

Analysts use a number of indicators to try to predict market corrections. But Duncan Rolph, managing member of Miracle Mile Advisors and a member of Forbes’ advisor network, generally likes two: the relative strength index (RSI) and the Chicago Board Options Exchange volatility index (VIX).

The RSI “measures the magnitude of price movements in a stock or index,” Rolph writes on Forbes. When it rises above 70, it means a stock or index is overbought and points to a correction. (Generally, the RSI stays within a range of 30 to 70.)

On the other hand, the VIX is a measure of investor sentiment, based on S&P 500 options. When it’s low (roughly below 20), Rolph says it may indicate that investors “are complacent and aren’t pricing in a possible downturn.” That, in turn, can mean a sell-off is about to happen, and if it’s big enough, it could be a correction.

Yet both measures are imperfect predictors of corrections. They’ve been wrong many times, pointing to corrections that never happened. Rolph recommends using them merely as guidelines.

What Should You Do During a Market Correction?

During a big sell-off, it’s tempting to join the herd and cut your losses. In certain circumstances, like if you need the money urgently, this may be the wise move. But for most investors, the best move is to wait it out. As mentioned earlier, corrections last an average of 112 days or about four months.

In fact, instead of selling, the smart money buys during a correction. As prices tumble, quality stocks can become available at a discount. That said, there’s always the chance that the tumble will become a free-fall, so buying during a correction is for hardy souls and investors with long-range horizons.

For some investors, a market correction is an opportunity to buy stocks at a discount. The Bottom Line

Technically, a market correction is when an index slides 10% or more from its last peak. This happens, on average, roughly every other year and lasts, on average, about four months. For long-term investors, a market correction can be a buying opportunity.

Tips for Investors
  • Broadly diversify your portfolio. Adding non-correlating asset classes, such as real estate and commodities, to your stock investments will help buffer them during a market correction. The idea is that when stocks go down, the non-correlating assets will go up, smoothing out the lows of your securities’ performance.
  • Don’t go it alone. Hire a professional who’ll have the research and know-how to optimize the return of your investments and minimize the risk. We can help you find the right advisor for you. Just use our SmartAsset financial advisor matching tool, which will recommend up to three in your area, vetted by us and based on your answers to our multiple choice questions.

Photo: iStock.com/jmiks, iStock.com/yacobchuk, iStock.com/marrio31

The post Market Correction: Definition, Duration and Everything Else You Need to Know appeared first on SmartAsset Blog.

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