Stock market correction is a part of business cycle, even though this is very painful for investors.SP 500(SP500 is an equity index of US Large cap stock ) already lost 2.3 trillion from its peak May 2015 till January 16. This index lost 1.3 trillion since from the January1 2016. Apple(Largest market cap company in the world) alone lost $218 billion.
SP 500 is down 8 percent this year including 2.2 percent down Friday january15, 2015.According to the us stock market rule, Market is considered in correction mode if market hits below 10 percent label from its peak and bear if market hits below 20 percent label from the peak. So right now us stock market is in the market correction territory as SP 500 already in the correction territory and possible candidate for bear market. If market sales off continues, this is very possible that we will be in the bear market within a few weeks.
Below is the comprehensive list of stock market correction of SP 500 from 1950 to today and S&P 500 chart also represent 10 biggest market correction form 1950.
(Click to enlarge)
DataSource: Yahoo Finance
S&P correction history table indicates that we entered into market correction every 3 year form 1950 to present. Majority of the s&P 500 correction was less than 15 percent correction and most of the stock market ends in October and November.
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Data Source: Yahoo finance
The S&P 500 correction history chart shows the 10 biggest correction happens in the USA from 1950 to present including the October 24, 2015 market correction.
Now we will discuss the myths about the stock market correction and test the myth based quantitative analysis:
Myth1# days between correction length is long means big correction.
Investors have general misconception that if length of days between corrections is long, market will make big correction. Truth is there is no significant correlation between length of days between correction and percent of correction. This is true for s&p 500 data. Market correction mainly depends on business cycle.
The above chart shows the SP 500 market correction from 1950 to 2015. Average correction was 14 percent over the time. Max correction is 20 percent. Market correction has no correlation between length of days between correction and percent of correction.
Myth2# Length of correction and days between corrections has positive correlation
It seems to be length of correction and days between corrections has positive correction is positive. Data shows that they do not have any significant correlation. This means if number of days between correction lengths is long, it does not necessarily mean length of correction would be big. They are mostly random events or they have very few correlation.
Myth#3: Correction is disastrous for stock market.
As market goes down, all the news paper and financial media screams that what problem would happen if market goes down and ultimately would head toward a correction. Actually correction is good when stock market is overvalued. Correction in overvalued stock market prevents stock market crash and helps stock market to adjust stock value with historical average price. Currently S&P 500 index’s adjusted price-to-earnings (CAPE) ratio value is close to 25 and was 27 when index was peak at May 2015. But historical average CAPE value is only 17. Stock market CAPE index 26.45 is 93 percentile point. This means CAPE ratio went 7 times out of 100 times in the history that high point. In other words, probability of CAPE ratio 26.45 is 7 percent out of 100. This indicates clearly market is overvalued and S&P 500 correction is necessary for the healthy stock market. Even if we look at s&p 500 stocks components, we see all the stock made a pull back and go sideways, before big move begins.
Myth #4: Stock market correction means bear market.
People think that stock market in the correction territory means we are in the bear market or we are heading toward the bear market . However from statistics we see different outcome. From 1950 to present days, SP 500 had 23 correction and 9 bear market- indicating 72 percent time market correction and only 28 percent times market correction leads to bear market. Statistics clarifies that we have only one fourth possibility heading toward recession or bear market form current market correction and we will enter into correction territory every 2 year. From this results, we can conclude that investors should not worried about market correction and bear market rather they should look for to pick right stock and take advantage of bear market. Because investor will make make money every 3 times out of 4 times, if they buy stock during the correction. This is a highly probable odd ratio for the investors.
Myth # 5: All the stock price will fall sharply during the correction
General investors idea is that all the stock price will fall down sharply during the correction. Truth is only over valued stock and weak stock price will fall down hardly in order to adjust with historical value. Stock market correction is golden opportunity for the value investors as they find the right bargain for some highly desirable stocks after market correction.Value Investor Warren buffet famous Quote “ Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” This quote is perfect for those investors who wants to take opportunity of market correction because of other people ignorance and wrong psychology.
Another point is that all stocks are not get crashed by market correction. Only the overvalued stock gets hard hit. Good stock easily hold the support line and even if price of good stocks fall down, they retrace to the support level rapidly.
Myth# 6: Frequency of market correction means end of bull market
There is a general misconception that beginning of correction means end of bull market or heading toward the end of bull market. We had longest bull market from 1990 to 2000. During this period, we had four market correction- July 16, 1990- October 11, 1990, October 07, 1997- October 27, 1997, July 17, 1998- October 08, 1998, July 16, 1999- October 15, 1999 respectively. Average time between two market corrections is 2.5 years which is less than average market correction of 3 years. This statistics indicates that frequency of market correction is not indicative of end of bear market rather indicative of a sustainable bull market.
Stock market correction is inevitable. Investors should not fear the correction as correction helps to prevent market crash and helps market to perform right way. Key takeaways are investors should know how to manage his position in the correction market. Lot of famous investors including Warren Buffet take advantage of market correction as price becomes cheap because of market correction. Another point is high beta stock has more risk at the time of market correction. Investors should know their risk tolerance before any investment decision.