What Is A Stock Market Correction?
A stock market correction is a sharp drop in stock prices over a specific period of time. Corrections are typically defined as a decline of at least 10 percent in the major indexes after a significant rise. While corrections can happen anytime and for any reason, they are often triggered by unexpected economic events or short-term economic news. Corrections can cause investors to panic, as stock prices can drop quickly and significantly, leading to losses. That’s why investors need to understand the research around stock market corrections so they can better prepare for and manage any market fluctuations that occur.
Types of Stock Market Corrections
When it comes to stock market corrections, there are four basic types. The type of stock market correction that occurs depends on the reasons for the downturn, how quickly the stocks drop, and for how long the correction occurs. The most common types include:
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Bear Market Correction: Also known as a major market correction, this type of stock market correction actually takes place over more than a month and is ignited by a significant macroeconomic event, such as a recession. Stock prices drop 20 percent or more over an extended period of time, making it the most severe type of correction.
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Fading Correction: This occurs when a stock price quickly drops, followed by a period of gradual recovery. Fading corrections also occur in lesser degrees and generally last up to a month or two.
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Bull Market Correction: This type of stock market correction is characterized by an increase in stock prices, however not as much as the bull market that preceded it. It takes place over a few weeks and results in stock prices increasing, though not as significantly as they did before the correction.
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Market Reversal: This type of correction happens when stock prices rapidly drop, followed by a sharp increase. Over the course of a few days, stock prices can quickly drop 10 percent and just as quickly, jump back up.
Causes of Stock Market Corrections
There are a variety of factors that can cause a stock market correction. Some of the most common include:
• Economic Slowdown: When the economy slows, businesses and consumers tend to cut back on spending, which can lead to stock prices dropping.
• Political Events or Government Policy Changes: When governments change or political events such as elections occur, it can lead to turmoil within the stock market.
• Market Overvaluation: When stocks become overvalued, investors may panic as they become concerned about the sustainability of these prices, which can cause stock prices to drop.
• Interest Rates: An increase or decrease in interest rates can cause investors to become wary of the stock market, leading to stock prices dropping.
• Profits Deteriorating: When companies that are publicly traded begin to report lower profits than anticipated, investors may become concerned and rush to sell their stock, causing a market correction.
Signs of a Stock Market Correction
If you keep a wary eye on the stock market, you can typically spot signs of a correction before it actually takes place. Here are a few key signs to watch out for:
• Investors become overly cautious: When investors become overly cautious, they start to sell off their stocks, which leads to a drop in stock prices.
• Large companies report lower than expected profits: When major companies begin to report lower profits than the market anticipated, it can concern investors and can lead to a market correction.
• Professionals warn of a downturn: When market professionals such as economists and analysts issue warnings about a potential downturn in the market, investors may become overly concerned and begin to sell off their stocks.
• Fundamental metrics show a market peak: Fundamental metrics such as the price-earnings ratio or market capitalization are indicators of market health. If these metrics show that the market is overvalued, it is a sign of a potential correction.
Managing a Stock Market Correction
Although corrections can be unnerving, there are strategies to help manage a stock market correction. Here are a few tips to consider:
• Don’t panic: A stock market correction can be unnerving, and the abrupt drop in stock prices can be disconcerting. However, the impact of a correction shouldn’t be overstated, as prices will likely eventually recover.
• Don’t overreact: Corrections may seem like a good time to buy stocks as they can often be heavily discounted. But it’s important to resist the urge to buy up everything on sale. Instead, stick to your plan and only invest in stocks that are in line with your long-term goals.
• Diversify and rebalance: Diversifying your investments can help reduce the impact of a market correction. By investing in different asset classes and sectors, you can help manage losses that may occur. Additionally, it’s important to periodically rebalance your investments to ensure that your portfolio is aligned with your goals and risk tolerance.
• Do your research: It’s important to take the time to research the stock market and understand the macroeconomic context when there’s a correction. Knowing what’s going on in the market will help you assess the potential risks and rewards associated with whatever investments you decide to make.
• Take a long-term view: Many investors panic when stock prices drop because they’re focused on the short-term impacts. However, taking a longer-term view is important when it comes to investing. Markets fluctuate, and if you have a diversified portfolio of investments, stocks will likely rebound over time.
Understanding stock market corrections is important for all investors. Knowing the types of corrections, the potential causes, and being able to spot the signs of a correction can help investors prepare and manage any market downturns. Additionally, utilizing strategies such as diversification, rebalancing, and maintaining a long-term view are key for managing a stock market correction. Although corrections can be stressful, understanding the basics and having a plan in place can help investors manage these adversarial situations.
