Editor's note: This article was originally written in April 2018
During the latest bout of market volatility, you may have heard at least once that the Nasdaq, S&P or Dow has slipped into “correction territory”. It is usually said with an ominous tone and is therefore often scary for investors, but many aren’t aware that it has a specific meaning and has implications for the market that are not usually negative.
The first thing that should be clarified is what is meant by the phrase and why it is used only at certain times. To the average investor, a correction would seem to indicate any reversal of a recent move, but for market participants it has a specific meaning. For a working definition of a “correction” as it applies to the stock market, I turned to Investopedia, who define it as, “A reverse movement, usually negative, of at least ten percent in a stock, bond, commodity or index to adjust for an overvaluation”.
There are two important things to note here. First, in market terminology a reversal of direction is only a correction when it reaches ten percent. That seems a little arbitrary; what is the effective difference between a 9.8% drop and one of 10%? For investors, very little if anything, as both damage your wealth. At some point, though, such a move needs to be differentiated from what could be expected in normal volatility, and the consensus is that that point is reached at the round number of 10%.
The second thing to note is that a correction is seen as an adjustment for an overvaluation, something which is implicit in the word itself. When you understand that important point, it should be clear that corrections are not as worrying as they may at first sound. If the individual stock or the overall market is overvalued, a correction is often not only necessary, but even helpful.
As you can see from the chart above, the last thing you should do when you hear that the market has “moved into correction territory” is sell. A breach of the 10% level is often followed by a recovery. It could be that stocks will head lower again at some point, but even if fundamental factors point to that, you are still usually better off waiting for a bounce on which to sell. That could mean losing a few extra percentage points if the decline continues, but that usually only happens when there are real, fundamental reasons for the drop.
That was not the case this time around. The decline was sparked by fears that inflation was on the horizon, which could prompt the Fed to raise interest rates more rapidly than anticipated, but the key word here is “fears”. There is no evidence yet of inflationary pressure, so we are still in a situation where corporate profits are strong and growing, and overall economic growth is better than it has been for years.
The qualifier to that, of course, is that sentiment matters, but that is less relevant today than it was in the past thanks to the rise of algorithm-driven computerized trading. Computers don’t feel fear or panic, and they are programmed to position for the most likely outcome of a 10% drop, a bounce. That then becomes a self-fulfilling prophecy.
So, next time you hear or read that stocks are in correction territory, don’t view it as a reason to sell. Pause and take stock of fundamentals. If the situation is similar to 2008, when banks were going under and liquidity was drying up, or if economic data suggests a recessionary environment, then at least consider trimming your holdings. However, if, as is more often the case, overvaluation, fear and negative sentiment rather than data and events are driving the move, sit tight and perhaps even consider buying if you have cash to deploy.