Updated: Jul 12
Growth stocks are up double digits this year (through Aug. 9th). So are value, mid-caps, small caps and international. Second quarter corporate earnings have crushed the street's expectations and most companies are now in better financial shape than they were pre-pandemic. Oh, and those digital coins backed by the full faith and credit of the blockchain continue to see positive inflows from retail and institutional investors.
It's times like these when investor rationality is replaced by ill-conceived precognition. If stocks continue to climb higher despite the delta variant rampage, rising debt levels and another trillion-dollar government spending package passing through Congress, one could easily ascertain the market is overvalued and due for a pullback. What goes up must eventually come down, right?
I once had a client who at every meeting, claimed the stock market was due for a correction. In fact, he was certain of it. This started back in 2016 and it wasn't until two full years later I could finally congratulate him on being right. Meanwhile, the stock market returned more than 40% during that time period.
If you throw enough mud at the wall, some of it will stick. The real question isn't "IF" we're due for a stock market correction, but how to deal with one when it arrives, because it will. But before we delve into that, let's first define what a "correction" is.
What is a Stock Market Correction?
A stock market correction is a term that describes when assets, whether that's individual stocks or indices like the S&P, decline between 10% - 20% from their recent highs. This should not be confused with a "stock market crash" which is defined as a steep, unexpected drop that can occur in a few hours or days, i.e. Black Monday, 1987. Corrections, on the other hand tend to happen over the course of a few weeks/months/years and are considered more "normal" in nature than crashes.
What happens when stocks fall more than 20% from their highs? That's a bear market, a greater than 20% dip in assets from previous highs, much like what happened to the broader market from Feb.19, 2020 through the following month when stocks fell 34%. Thankfully, bear markets are less common than corrections
Market Correction - 10% - 20% drop in assets over a few weeks/months/years.
Market Crash - Rapid, unexpected drop in assets over a few hours/days.
Bear Market - Greater than 20% drop in assets over a few weeks/months/years.
What Causes a Stock Market Correction?
A global pandemic? Rising interest rates? An alien attack? While these are all reasons why market corrections may occur, it's important to understand first why stocks fall.
At its core, the stock market is one giant gathering of buyers and sellers. When orders placed to sell a security exceed those to buy, the price of that security falls. And the size and velocity of said fall is based on the ratio of sells to buys.
Any number of economic and financial factors may contribute to a market correction - poor health of the economy, an oil supply glut, stagflation, increase in corporate taxes, a new disruptive technology, trade wars, excessive government spending, a terrorist attack, the list goes on.
But one thing all of these catalysts have in common is they're rooted in fear, and fear can move mountains.
Since the market is always forward-looking and discounting future revenue, earnings, industry-specific risk, etc. back to the present, the fear of what's yet to or may likely occur can cause a substantial disruption in current asset prices as investors, both large and small, all simultaneously pull the sell trigger. So it's not necessarily the news of a terrorist attack or a high inflation reading that causes investors to sell, but the fear of what that news or event might mean for stocks going forward.
How Often Does the Stock Market Have a Correction?
The last major drawdown started in Feb. 2020 and ended a month later after stocks lost over a third of their value due to the pandemic. Prior to that, the market experienced a 19.8% correction from September through December, 2018.
History, however is but merely a guide. Just because it's been more than 18 months since the last bear market doesn't necessarily mean a correction is in our near future. And trying to time when a correction will occur by getting out of the market is dangerous as the opportunity cost of waiting in cash can be massive, especially if you have a 7-year run like we did from 1990 - 1997 when the S&P returned 302%.
Will There Be a Stock Market Correction?
Yes, I'm 1 million percent sure and have never been more certain about anything in my life.
That doesn't mean, however that I have any clue as to when it will happen. And if you meet someone who claims to know the specific date and time of the next correction or crash or bear market, take your money and run as fast as you can in the opposite direction.
More important than determining "IF" and "WHEN" a stock market correction will occur is knowing what to do and not to do when it happens.
Navigating a Stock Market Correction
First and foremost, you should have a good understanding of your risk exposure. Are you heavily weighted in tech stocks, small-cap growth, cryptocurrency, treasuries? A globally diversified portfolio of 50% stocks and 50% bonds will react much differently to a market correction than a 100% domestic stock portfolio. Understanding risk will help you establish the right expectations regarding potential upside/downside movements in your portfolio and allow you to better control your emotions when things get out of control.
Second, don't be afraid to rebalance. For example, a 70/30 portfolio of stocks and bonds may shift to something more like 62/38 during a market selloff. Rebalancing would involve selling a portion of your 38% in bonds and using the proceeds to buy stocks, thereby adjusting your weightings back to the initial 70/30 target. In doing so, you're concurrently buying low (stocks) and selling high (bonds) while remaining in line with your financial objectives.
Lastly, stay calm and don't try to time the market! Sure, you might get lucky once or twice but remember, the game of investing is won over the long run through patience and perseverance.
If you're not sure exactly how much risk exposure you have, when and how to rebalance your investments and need someone to help guide you through the emotional roller coaster that is the stock market, a trusted fiduciary can help!