Rick Welch: Dollars and $ense

Stock Market Corrections

cor·rec’tion   n.   1, a change that makes something right, true, accurate    2, an adjustment or rectification

As defined, a correction sounds like it might be a good thing.  If so, why do many investors cringe when they hear  this word?  Perhaps they are familiar with what a correction can do to their portfolio, but do not understand the role corrections play over the long-term.  As soon as their portfolio starts to look good, they fear the next correction must be right around the corner.  Of course, sometimes that intuition proves correct, other times not so. Long term investors know that corrections are just part of the ebb and flow of the financial markets. In considering what a correction is we should also define what bull and bear markets are. Then we should discuss, from a historical perspective, how often they occur and whether they can be accurately predicted. 

First, let’s look at the difference between a stock market correction and a bear market.  A market correction is a period of selling or temporary stock price declines.  A correction is often referred to as a broad market decline of at least 10%. (Smaller declines, say of about 5%, are often referred to as dips.) Since 1945, there have been 27 corrections, which as a group, saw declines averaging 13% and lasting about 70 days. During this period a correction occurred about once every 2.5 years. Since the recent recession, there have been 3 corrections: in 2010 (16% over 69 days), 2011 (16% over 150 days) and 2012 (10% over 55 days).  A bear market is a long-term period of market declines which typically starts when a correction exceeds 20%. On average, bear markets last about 14 months and result in a cumulative price decline of about 24%.  Since 1945, there have been 13 bear markets, for an average of 1 bear market every 5.3 years.  During that period, the longest bear market lasted 30 months (2000 to 2003) and the deepest decline was seen in the most recent recession ending in early 2009 (-51%).

When we look back over the last 3 years, we see that corrections take place within bull markets, which are defined as long-term periods in which investor sentiment is positive and stock price levels are generally climbing.  The length of bull markets has varied over time, from as short as 2 years to as long as 9 years, with an average of about 4.7 years.  The 1990’s bull market lasted over 9 years and saw the S&P 500 Index increase 417%. The current bull market, which started in March 2009 (4.8 years old), has shown an increase of 169%, which increase is in line with the long term average.  The duration and returns of bull markets are best viewed in light of interest rate and GDP growth conditions and the magnitude of the downturn prior to the start of the bull market, rather than merely the length of the run.

Unfortunately, having a better understanding of corrections does not allow investors to gain any real advantage in predicting the next one.  Most savvy investors look at corrections as buying opportunities within fully priced bull markets.  As we move into 2014, it is interesting to note that since 1945, the S&P 500 has climbed more than 25% in 14 different years, as it did in 2013 – in the years following each 25% rise the S&P climbed on average an additional 8.7% and was up in 11 of 14 years.

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