Simone Lawson
A market correction is a specific fall in value of at least 10% but less than 20% from a recent stock market high. There is no universally accepted definition of a correction, but most people consider a correction to have occurred when a major stock index, such as the S&P 500 or Dow Jones Industrial Average, declines by more than 10% from its most recent peak. A bear market, on the other hand, is defined as a decline of 20% or greater. The average time to recovery from a 10%-20% correction is eight months.
| Characteristics | Values |
|---|---|
| Decline in the market | More than 10% but less than 20% |
| Average time to recovery | 8 months |
| Average duration of correction | 4 months |
| Volatility index | Above 20 indicates weaker market sentiment |
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What You'll Learn
A market correction is a drop of more than 10% but less than 20%
A market correction is a drop in the market value of more than 10% but less than 20%. This definition is generally accepted, although there is no universal standard. A decline of less than 10% is often referred to as a "dip" or "pullback".
Market corrections can be identified by tracking major stock indexes such as the S&P 500 Index or the Dow Jones Industrial Average. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic US stocks. The CBOE's Volatility Index (VIX) is another critical measure of market volatility, often referred to as the "fear index".
Market corrections can be unsettling for investors, who may worry about when the market will level off and turn around. The average time to recover from a 10%-20% correction is eight months. In contrast, the average time to recover from a 5%-10% downturn is three months.
It's important to note that market corrections are different from bear markets, which are defined as periods with cumulative declines of at least 20% from the previous peak close. Bear markets tend to last longer, with an average decline of 46.5% over 1.4 years, while bull markets have averaged nearly nine years since 1987.
Preparing for potential market downturns is essential for investors. This includes creating a financial plan, reviewing risk tolerance, and considering investment strategies that can help weather significant downturns.
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A bear market is a decline of 20% or more
A bear market is a period in which there is a cumulative decline of 20% or more from the previous market peak. It is typically measured by the number of days it takes to reach the lowest close after falling by at least 20% and includes weekends and holidays.
Bear markets are unpleasant periods for investors, but they do occur periodically, with the average bear market lasting around 14 months. They can be caused by a slowing or shrinking economy, investor fear, or outside events such as wars, attacks, or oil supply shocks.
It is important to distinguish between a bear market and a market correction. While a bear market is a decline of 20% or more, a market correction is typically defined as a drop of more than 10% but less than 20%. Market corrections are unsettling for investors, and the average time to recover from a 10%-20% correction is eight months.
Preparing for a bear market is always a good idea. Investors should consider creating a financial plan, reviewing their risk tolerance, and adjusting their asset allocation to ensure their portfolios are designed to withstand the level of risk they are willing to take.
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Volatility measures like the VIX can indicate weaker market sentiment
Volatility measures like the CBOE Volatility Index (VIX) can be used to indicate weaker market sentiment. The VIX is often referred to as the "fear index". It is a critical market volatility measure that presents the market's expectation of volatility over the next 30 days. The VIX generally rises when stocks fall and declines when stocks rise. A higher VIX value indicates greater anticipated volatility and market uncertainty, while a lower VIX value suggests market stability.
The VIX is derived from the prices of SPX index options with near-term expiration dates, and it generates a 30-day forward projection of volatility. It is considered a crucial barometer for market participants seeking insight into investors' collective psyche. When the VIX is low, this suggests calm seas ahead. When it spikes, it signals approaching storms.
The VIX is also used to measure the level of risk, fear, or stress in the market when making investment decisions. Investors can use the VIX to get an understanding of market risk as well as investor sentiment. It helps market participants gauge potential risks and make informed trading decisions, such as whether to hedge or make directional trades.
The VIX tends to move in the opposite direction of the market. VIX values greater than 30 can signal heightened volatility from factors like investor fear and increased uncertainty. On the other hand, VIX values lower than 20 can signal increased stability in the markets.
While the VIX itself is an index and cannot be traded, there are funds and notes investors and traders can participate in to gain exposure to the index. For example, traders can trade VIX futures, options, and ETFs to hedge or speculate on volatility changes in the index.
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A slowing or shrinking economy can cause a market decline
A market correction is a decline in the stock market of more than 10% but less than 20%. A decline of 20% or more constitutes a bear market. A slowing or shrinking economy can cause a market decline, and there are several factors that can contribute to this.
One factor is stagflation, which is caused by a combination of slow economic growth and high inflation. Stagflation can be caused by supply disruptions, such as geopolitical conflicts, rising tariffs, or natural disasters, which lead to rising input costs for businesses. Stagflation results in a painful combination of fewer available jobs and reduced purchasing power for consumers. The traditional tools used to address slow economic growth, such as tight monetary policies, can worsen inflation, and vice versa, making stagflation periods prolonged and challenging to resolve.
Another factor that can contribute to a slowing or shrinking economy and market decline is a decrease in consumer spending. Consumer spending is the main engine of the US economy, and a softening of the labor market can lead to a decrease in household outlays. This can be caused by a "pulling forward" of spending on goods, as consumers rush to buy certain items before potential tariff increases, as seen with President Trump's tariffs. This results in a decline in future spending as consumers have already brought forward their purchases.
Additionally, a slowing or shrinking economy can be caused by a decline in external demand, particularly in countries with strong export sectors. This can have adverse effects on the regional trading partners of these countries, especially during globally synchronized recessions. Recessions can also be caused by sharp increases in asset prices and speedy expansions of credit, which can lead to a rapid accumulation of debt. As corporations and households struggle to meet their debt obligations, they reduce investment and consumption, leading to a decrease in economic activity and a potential market decline.
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Outside events like wars or attacks can spook the market
During World War I, stocks fell by around 30%, and markets were closed for four to six months. However, when the markets reopened in 1914 or 1915, the Dow Jones Industrial Average (DJIA) rose over 88%. A similar pattern played out during World War II. Despite initial uncertainty, the U.S. market climbed 10% after Hitler's invasion of Poland in 1939. After the attack on Pearl Harbor in 1941, stocks dipped 2.9% but recovered within a month. From 1939 to the war's end in 1945, the Dow rose by 50%.
While war can introduce volatility, markets often adapt and rebound. Defense stocks, energy companies, and industrial production to meet military needs tend to fare well during wartime. The development of new technologies during conflicts can also benefit the private sector.
Recent conflicts, such as the Russian invasion of Ukraine, the Hamas attack on Israel, and tensions between the U.S. and Iran, have impacted markets. The World Bank predicted Ukraine's GDP would grow by 3.5% in 2023, despite a 30% crash in the first year of the conflict.
Market corrections refer to a decline of more than 10% but less than 20%. A decline of 20% or more is typically considered a bear market or a market crash. While wars and attacks can influence markets, they often do not push equities lower over the long term.
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Frequently asked questions
A market correction is generally defined as a decline of more than 10% but less than 20%.
A bear market is typically defined as a decline of 20% or more.
On average, market corrections last around four months.
It is important to have a financial plan and regularly review your risk tolerance. Ensure your investment portfolio aligns with your risk tolerance and financial goals.
