Market Correction

Market Correction Definition

Market Correction, usually referred to as a fall of 10% or more from its latest high, is a phenomenon quite normal in stock market to correct the prices of the index, stocks, commodity, etc., listed in the securities market due to various reasons such as declining macro-economic factors, intense pessimism across the economy, securities specific factors, over-inflation in the markets, and so on.

In market correction, when prices started to fall, a sense of fear prevails, and suddenly an active selling happens. The market selloffs run for a while, depending upon the strength of correction, and again after a point, the buying begins by putting an end. Almost all corrections have few similarities such as excess buying, euphoric attitude with a strong bullish trend, a sudden slump in prices, a fear-ridden market, consistent newer lows, adverse information regarding the economy or respective organizations, etc.

Example

From the year 1980 till 2018, the U.S market witnessed more than 35 corrections, and, in the same time zone, the most sought after index in the U.S stock market, fell around 15%. Few of these corrections led to bear markets, but the corrections favored bull markets more.

Market Correction

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Source: Market Correction (wallstreetmojo.com)

Why do Market Corrections happen?

It is quite difficult to time the market and to predict the exact point from where the correction would begin. But, the indications are quite evident for an approaching downturn. There are various ways through which market participants foresee the timing of market corrections, such as the charting method. The charting method observes and studies the prices to conclude the trend in the market.

Also, other indications such as negative economic situations, stock-specific adverse news with a lasting effect, unfavoured policy decisions by the government could lead to the downfall in the market. One of the most prominent reasons could be the euphoria, or intense buying sessions in the market too. To keep prices in equilibrium or to provide an accurate picture, the situation also warrants a correction.

How to Handle Market Correction?

Well, a sharp decline is quite difficult to digest even for a seasoned investor, but the corrections are healthy too if the tricks are known to the participants.

  • In the time of correction, the valuation of almost all stocks fall. The market selloff is the perfect time to purchase some fundamentally strong shares for a longer horizon at a steep discount.
  • It is also a good time to diversify the portfolio by including other asset classes such as bonds, commodities, real estate, etc. A further correction would happen in the future too, and it gives an essential lesson to the investors not to keep all eggs in one basket.
  • With the help of technical analysis, in most cases, a rough idea could be availed regarding the next movement of the prices. So, it also gets a good trading opportunity to bearish traders.
  • If the investor is sitting on fundamentally strong stocks, such as consumer products, then do nothing strategy also helps a lot. As in the future, the prices would move up; it won’t make a dent in the investor’s pocket if the time horizon is for a more extended period.

Advantages

Though it is considered as a negative or pessimistic scenario, it also brings some benefits too. A few of the most relevant ones are discussed below:

  • In the very early times, markets are being protected by laws, and there was a set rise or fall, after which the government used to interfere and put the prices to current ones. But, after the advent of the free economy, the deciding force behind price determination rested with the buyers and sellers in the market. So, in times of euphoria, or excessive buying on newer peaks with no sustainable reasons, the market needs to get corrected.
  • When a correction happens, usually all the stocks or the relevant security types dips. Most of the time, good quality stocks are also dragged in this frenzy, and it provides a great buying opportunity for good stocks at comparatively lower prices.
  • In a sharp market downturn, companies float share buyback offers as the market prices of the stocks could be low or closer to the fundamental prices, and people are found to be in a selling spree.
  • It also gives a good opportunity to cover up the positions for traders carrying the short positions.

Disadvantages

It is observed that when the market falls, the movement is quite sharp, and to the majority of stock market players, it affects negatively.

  • The falling market creates a panic in the market. Also, it brings upon a strong selling trend because a fear prevails that it could go further, and thus this trend continues. In these situations, even good stocks are being punished too. It hurts short-term or novice investors as their first experience turn out to be negative, and many times, these fears drive them out of the market.
  • The sudden downturn in the market affects the leveraged traders profoundly. Leverage is a double-mouthed sword, as it provides an option to earn or lose in multiples of one’s funds. The quantum of losses and earnings both gets magnified with borrowed capital. So, if the market falls sharply, the leveraged players suffer due to the additional charge of the borrowing along with falling prices of securities.
  • As it is evident from recent falls, the market takes away all the gains quite quickly what it has offered over time in market corrections. And, sometimes, the fall also brings an active bear market supported by a further decline in the prices. The prolonged bear market hurts the economy and is considered a big negative.

Conclusion

Though the prolonged market correction is painted in the negative color due to various reasons like losses in the securities, negativity in the economy, significant bearish movements, a healthy correction is quite beneficial to end the excessive buying, price equilibrium, and ending the bullish euphoria and thus required for a thriving market.

Recommended Articles

This has been a guide to Market Correction and its definition. Here we discuss how to handle correction, why does it happen, along with an example, advantages and disadvantages. You can learn more about from the following articles –

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