What Is a Stock Market Correction?

Recent market volatility has rattled many investors. Year-to-date, most pandemic-era growth stocks are down heavily, with the tech sector and the FAANG stock cohort suffering greatly. Most major stock market indexes are down from their all-time highs. Many investors are now steeling themselves for further possible market corrections, or even a crash and prolonged bear market in the worst-case scenario. 

What is a market correction?

A market correction generally refers to a rapid, sudden decline in the value of a stock market index, such as the S&P 500, Nasdaq Composite, or S&P/TSX 60. 

Generally, a 10% fall from the most recent peak of a major index qualifies as a stock market correction, whereas movements larger than that can qualify as a stock market crash. 

Corrections can last for indeterminate periods, often days, weeks, or even months. However, they do tend to be short-lived relative to true bear markets.

Bear market vs. market correction

A bear market occurs when a stock index experiences a period of prolonged price decline, generally measured in months or even years. 

Compared to a market correction, a bear market generally involves a decline of 20% or more from recent highs. Bear markets are usually accompanied by less than favourable economic conditions, such as high inflation or recessions. 

Conditions during bear markets tend to be highly volatile, with numerous short-lived rallies (bull traps) occurring amid a steady decline. 

Stock market crash vs. market correction

Compared to market corrections, true stock market crashes are usually more dramatic, sudden, and sharp. They’re often caused by a flurry of panic selling that causes significant declines in prices during intra-day trading or over a period of several days. 

In response to market crashes, numerous exchanges have trading halts, also known as “circuit breakers,” that either pause or suspend trading if a major index crashes. For example, the S&P 500 imposes circuit breakers at 7%, 13%, and 20% intra-day declines.  

How often do market corrections occur?

On average, a market correction occurs about once every two years, but can vary depending on the index. A highly volatile index like the Nasdaq 100 is more likely to experience a correction than a stable blue-chip one like the Dow Jones Industrial Average. Market corrections also become more likely following prolonged bull runs when valuations are running high. 

Prior to 2022, the most recent market correction (which eventually became a crash) came during March 2020 at the start of the COVID-19 pandemic. This did not manifest into a bear market due to the intervention of the U.S. Federal Reserve, which dropped interest rates and introduced quantitative easing to stimulate the market. 

Are we currently in a market correction?

As to whether we are now in a market correction, that depends on the market in question. 

The Canadian Market

In terms of the Canadian market, we are currently undergoing a correction, but not a bear market. At time of writing (June 20, 2022), the S&P/TSX 60 has returned -9.66% year-to-date, which is in correction territory but falls short of a bear market. The Canadian stock market has done well in comparison to other regions thanks to its high proportion of energy stocks, which have outperformed significantly in 2022. 

The U.S. Market

In terms of the U.S. market, they are currently undergoing a bear market after numerous corrections. 

Year-to-date, the S&P 500 is down 23%, the NASDAQ Composite is down 31%, and the Dow Jones Industrial Average is down 18%. The first two indexes meet the criteria for a bear market, and when averaged, the U.S. market as a whole is in a bear market. During this time, multiple intra-week corrections have occurred where the indexes finished 10% below their starting weekly values. 

Will there be another market correction?

While it is certain that there will be another market correction, sometime in the future, we don’t know when. Even the best economists and quantitative firms have trouble predicting this. Whether or not the market will correct again in the remainder of 2022 depends on a variety of factors, including:

1. How inflation in the United States and Canada continues to trend based on Consumer Price Index (CPI) releases, and how markets react.
2. How much central banks like the U.S. Federal Reserve and the Bank of Canada decide to hike interest rates, and whether or not the market expectations for that are met or surprised.
3. How economic indicators like gross domestic product (GDP) and employment figures turn out, and how markets respond.

Generally, when assets become over-valued in a low-interest rate bull market, there is a chance for them to revert to the mean (return to average values) in the future when the macroeconomic scenario is no longer as attractive. 

How to prepare for a stock market correction

Good investors always adjust their risk exposures based on their investment objectives and time horizons. Keeping losses minimal is just as important as maximizing gains when it comes to overall portfolio value. 

Preparing ahead of time for a possible correction can help you keep holdings in the green and drawdowns low. Here are a few ways to prepare for a stock market correction.

Diversify your portfolio

The simplest way to reduce the effects of a potential market correction is by reducing your equity exposure. This means sizing the allocation of stocks in your portfolio to a level that satisfies your risk tolerance. 

Having 100% in stocks can be risky for many investors. Some choose to lower this to 90%, 80%, or 60%, and allocate the remainder to investment-grade bonds, mutual funds, ETFs, gold, real estate, or cash. Keeping an allocation to assets other than stocks can give you dry power to rebalance into pummeled equity positions at a lower-cost basis following a correction. 

Invest in low-volatility market sectors

Investors can also reduce their sensitivity to a market correction by investing in more defensive market sectors like health care, consumer staples, and utilities. On the other hand, small- and micro-cap stocks, stocks with a high beta, and growth stocks are riskier investments. During bull markets, these stocks tend to outperform, but can suffer greatly during a correction. 

Focus on the long term

Sometimes, the best way to prepare for a market correction is to simply do nothing and stay the course. If you own a well-diversified portfolio of high-quality stocks and bonds, sticking to your investment strategy and ignoring the market volatility is a prudent move. This involves ignoring the urge to panic-sell, consistently making contributions, and re-balancing investments annually as needed. In the short-term, the stock market can be unpredictable, but over the long term, it trends upwards.