Market Correction

To the benefit of stock market pundits and news commentators, traders have taken several swipes at stock market valuations in recent trading sessions.  Nearly everyone looking into a camera has brought forth the ratings-driving word “correction”.  It is worthwhile to understand whether the U.S. stock market really is in a correction or even headed toward such a development. 

Just what is a ‘market correction?’

There appears to be a common thread in various definitions.  It is noteworthy that some of the most widely used and highly regarded reference for economics and finance do not even mention stock market correction, including The Economist Dictionary and Oxford Reference’s Dictionary of Economic Terms.

SOURCE	MARKET CORRECTION DEFINITION
InvestingAnswers.com	“price decline of at least 10% of any security or market index following temporary upswing in market prices”
Wikipedia	“sudden dramatic decline of stock prices across significant cross-section of a stock market, resulting in significant loss of paper wealth…often follow speculative stock market bubbles…”
Dictionary of Financial Terms	“a sharp, relatively short price decline that temporarily interrupts a persistent upward trend in the market or in the price of a stock”
Investopedia.com	“a 10% or greater decline in the price of a security [or index] from its most recent peak”
Thebalance.com	“A stock market correction is when the market falls 10% from its 52-week high.”

The last U.S. stock market correction began in January 2018 and culminated in the next month.  On January 26, 2018, the Dow Jones Industrial Average established a record high closing of 26,616.71.  It was a day of celebration that was followed by a day of anxiety when stock price immediately began falling.  Within two weeks the DJIA had declined 10.4% as investors fretted over interest rate increases and inflation.

Another began had unfolded in late 2015 and came to a dull thud in February 2016.   Investopedia.com has been keeping score and cites thirty-six discreet corrections in the U.S. stock market in the years 1980 to 2018, with an average 15.6% decline in stock values.  Deutsche Bank also monitors stock market moves and has concluded there is a correction on average every 357 days.  That is about once a year. 

It would seem stock market corrections are bound to happen.  Given the tendency of market participants to act with extreme enthusiasm or pessimism, the give and take of supply and demand for stocks is bound to result in some volatility in prices.    

To predict a market correction, one method monitors various stock market indices.  One underperforming index may be followed by a similar index.  A trend of underperforming is considered a leading indicator of overall market correction.  Others are keen adherents to a technical indicator called the Relative Strength Index (RSI for short), which measures market momentum.  A market correction might be predicted when there is a divergence in the RSI and broader market highs.  In other words if the RSI is declining and market indices are reaching new high price levels, it is time to be careful.  Yet a third harbinger of a corrective downdraft is based on  particular stocks that have been exceptional market performers, rising more than 50% over the past year.  When these stocks begin to lag the broader index, it is thought to be a signal of full valuation and potential correction.

It might be a wise strategy to position for what seems to be inevitable.  Just what shape that strategy might take is another matter.

Unlike the most recent stock market correction that unfolded in just days, most significant stock price adjustment events play out over a period of time.  An analysis by MarketWatch of corrections in the years 1945 to 2013, found that the average correction lasted 71.6 days or about 14 calendar weeks.  For some that may seem like a very short period, but for the astute trader there could be time to capitalize on falling prices and new low price levels in interesting stocks.  These strategies do not have to be limited to the short-term trader.  Long-term investors with a well-researched target list for future long positions may find attractive valuations in the nail biting days of a market correction.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.