Market Corrections are Healthy (?)
cor·rec’tion n. 1, a change that makes something right, true, accurate 2, an adjustment or rectification
As the markets, both here and abroad, have retreated over the past few weeks we have heard from many experts that a market correction is a healthy occurrence within a normal bull market. If market corrections really are healthy, why then are they so painful to live through? During any period of panic selling, it is then that we must maintain a tight focus on our long-term investing goals. History suggests that the selling will stop, and buyers will once again step in.
As defined, a correction sounds like it might be a good thing. A correction returns (“corrects”) share prices back to their longer-term trend. If that is the case, then why do investors cringe when they hear the word “correction”? 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 differences between a 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% (but less than 20%). Smaller declines, say of about 5%, are often referred to as dips. Since 1974, there have been 25 corrections, which as a group, saw declines averaging 13% and lasting about 70 days. A bear market is a long-term period of market declines which typically starts when a correction exceeds 20%. Unfortunately, it is impossible to predict when (or whether) a correction will reverse or turn into a bear market. Since 1974, only 5 of the 25 market corrections have deepened into bear markets (1980, 1987, 2000, 2007 and 2020). On average, bear markets last about 14 months and result in a cumulative price decline of about 24%. Investors should take note that bear markets often end as abruptly as they began, with a quick rebound that is very difficult to predict. A good example here is the Covid-fueled bear market of Q1 2020, which lasted just 33 days from the previous high on February 19 to the trough on March 23 and registered a share price loss of 34%. By the end of 2020, the market was back on track (S&P 500 was +16.25% for the year). The most recent bear market occurred in 2022 as the Fed began its fight against inflation by aggressively raising interest rates – that bear market lasted 10 months and resulted in a market drop of 25%.
When we look back over the past 50 years, we see that corrections take place within bull markets, which are defined as long-term periods, between bear markets, 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 6.7 years. 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.