5 Misconceptions about Market Corrections
The 2017 calendar year provided one of the most beneficial runs the stock market has endured in decades. It seemed like each new day brought a new record-high close. However, that wild ride upward had to meet an end at some point. There are a lot of reasons that markets can cool off, ranging from jarring events such as a singular, massive selloff to the geopolitical strife that riles the nerves of investors. In early 2018, the markets experienced a severe correction.
Many people mistake the event of a correction as something more than it typically represents. In most cases, corrections are cooling actions that clamp down on a market seemingly running amuck. There are many misconceptions about market corrections, and below you'll find five of the most common misconceptions about market corrections.
Size and Duration of Correction
One of the biggest misconceptions about market corrections is that there is some sort of correlation between size and duration. Market corrections can take place quickly and drop significantly, or drag out in duration but drop very little. It is important to keep in focus the definition of a market correction. The following is a helpful chart compiled to define various percentage drops in the market; be sure to focus on the definition of a correction:
• A drop of less than 5% - market pause
• Drop of 5% to 10% - market dip
• Drop of 10% - market correction
• Drop of 20% or more - Bear market
• A drop of 50% or more - market crash
• A drop of 80% or more - market depression
The size and duration of a market correction will vary, but to accurately define a correction one must focus on the percentage of the drop, and worry less about the length of time or size of the drop, in terms of points.
The Fed "Put"
Contrary to popular belief, the Federal Reserve or other central banks around the world have no target amount for equity markets at which these entities would act to prevent stocks falling below a certain level. Even amid the recent correction in February 2018, the Wall Street Journal pointed out a Fed "put" was far away, if existent at all. As no two market corrections are the same, the Fed does not look for a "put" that establishes a line at which stocks will not be allowed to fall below in terms of value.
This misconception is flawed from the outset with the use of a term such as "fair value." There is a common belief during a correction that stocks should return to a "fair value" level before they stop going downward instead. History has shown that market corrections are inconsistent with price-to-earnings ratio the correction stops at.
Many investors believe that an overheated market, such as the one experienced throughout 2017, must revert to a basic price trend after such a period. After all, stocks cannot go up indefinitely without reversing course. Data such as a moving average is often viewed as a means of price support amidst a falling market, but there is no consistent moving average that exists for every correction. Stocks will typically dip below their 200-day moving average.
Changes in the Data
No two runs in the market, whether Bear and Bull or correction and boom, are the same. Markets can respond to a variety of factors, with investors first looking for signs of data that show a turnaround is coming that will ease concerns. As each market correction is different, the data points that investors look for as a sign that the correction is ending will be different. Not all market corrections are a result of a weakening economy, so looking only at gains in the economy fails to focus on the data that shows whether the correction has ended or not.
There are more than just five misconceptions about market corrections. In the end, market corrections often lead to overreaction on behalf of investors. Dispelling some of those myths surrounding corrections can help refocus minds and markets. For more information about what market corrections mean and how it affects you, call your advisor at Hughes Warren.