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5 Misconceptions about Market Corrections

5 Misconceptions about Market Corrections

April 13, 2018

In any given year, the markets can send investors on a wild ride. While the market itself may seem timid in its behavior at times, rising and falling moderately throughout the year, it can also go on extensive positive runs such as it enjoyed throughout much of 2017. Conversely, it can enter correction territory from time to time that makes investors jittery, even though it may not last very long. A market correction, as defined by the New York Times, is a "10% drop in stocks from a peak." Take the S&P 500 for example; in 2018, the S&P entered correction territory in February after falling 10.16% from its high on January 26th.

That might seem like an arbitrary number, 10%, but it does have meaning and it is important to understand corrections. Most important of all is the value in dispelling the misconceptions that exist. Here are five big ones to keep in mind.


Varying Sizes and Durations

No two market corrections in history have had the same duration, nor delivered the same changes in value for the market. For example, the most recent correction on the S&P 500 technically only lasted for 13 days in total and brought that 10.16% change in value (downward). By comparison, there was a correction that began on April 29, 2011, that lasted 157 days and brought a correction of 19.4% to the S&P.

The length of time between corrections on the market is not an indication of an upcoming correction. It is not an indication of how severe the correction will be and is not an indication of how long it will last. For example, the April 29, 2011 correction lasted longer and had a more significant impact than the following correction of May 21, 2015. However, the 2011 correction came just one year after a correction, while the 2015 correction occurred after four years without one occurring.


Fed "put"

Many believe that the Federal Reserve maintains a target level in mind for equity markets and that it will act to ensure that stocks do not fall below a certain level. Investors refer to this as the "put" option. The Fed does not maintain an actual "put" for every correction but rather adjusts when it is believed that the market can be propped up. A 2016 correction saw the Fed hold off on raising rates to prop up the economy, while the most recent correction in 2018 saw no such activity from the Fed.


Fair Valuations

Some investors will look for stocks to return to "fair value" before they stop going down. The problem with this concept is the subjectivity of "fair value." The history of market corrections in the US has shown that there is no consistent measure of price-to-earnings ratios in the market, or where the correction will stop in terms of how badly it ravages the market.


Moving Averages

Moving averages are used as a price support mechanism for falling markets. The idea behind moving averages is that markets need to revert to typical price trends after an overshoot, or the overheated economy in this recent case. There is no consistent moving average that can always act as a floor for the market.


Changes in Data

Finally, as mentioned above, there are different reasons behind market corrections and those different root causes can lead to changes in the data used to judge a correction. This most recent correction in 2018 was built upon fears of a market that was simply too hot. It is possible for the markets to surge too high, too fast, and it then becomes difficult to sustain that growth realistically over time. Corrections, in this case, are a matter of cooling an overheated market and investors look to different data points for guidance.


The market correction in 2018 was brutal on the surface, with CNN noting the 1,175 point drop in the Dow for a single day to kick-off the madness was a record. However, it was only a record based on points lost and nowhere near the worst drop in value by a percentage, given the Black Monday 1987 drop of 22% in value in one day.


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