In case you haven't noticed, things have been a bit bumpy over the past couple of weeks after a historically strong start to the new year.
In the first quarter, the broad-based S&P 500 (^GSPC 1.99%) galloped to its biggest quarterly gain since 1998, with all three major indexes, the S&P 500, Dow Jones Industrial Average (^DJI 1.61%), and Nasdaq Composite (^IXIC 2.68%), rallying to all-time closing highs in April. It seemed as if the market could do no wrong, with the indexes more than doubling their historic average annual return, inclusive of dividend reinvestment and when factoring in inflation, through four months.
May, however, put no "spring" in investors' steps. Rather, the U.S.-China trade war escalation, persistent bond-buying that pushed down U.S. Treasury rates, and the threat of tariffs now being imposed on Mexico shook Wall Street to the core. All told, the S&P 500 fell 6.6% in May, its second-worst performance in May since the 1960s, according to Bloomberg, all while wiping out $4 trillion in market value.
With the S&P 500 now down close to 7% from its all-time high, Wall Street and investors are left to weigh whether we're on the verge of our 38th official stock market correction since the beginning of 1950. A stock market correction is traditionally defined as at least a 10% decline from a recent high, with a "bear market" representing a minimum 20% pullback from a high.
Regardless of whether a genuine stock market correction is in the cards or not over the coming days, weeks, or months, it's important that you understand the three basics of downtrending markets. Consider this a crash course in the must-knows of stock market corrections.
1. Stock market corrections happen a lot more often than you realize
The first clue you may have taken from a statistic I divulged earlier is that stock market corrections aren't the rarity that the media makes them out to be. Investors are often shocked when the stock market heads lower by any significant amount, but the fact remains that it happens all the time.
According to data aggregated by market analytics firm Yardeni Research on the S&P 500, there have been 37 stock market corrections of at least 10% (i.e., not rounding up to 10% for losses totaling between 9.5% and 9.9%) since the beginning of 1950. Through May 31, this works out to a bona fide correction every 1.876 years.
Understandably, the stock market isn't going to stick to a schedule of averages. Sometimes we can go years without a real correction. For instance, there was about a seven-year period between the third quarter of 1990 and the third quarter of 1997 where the S&P 500 only underwent two notable drops of 8.9% and 9.6%, neither of which qualifies as a true stock market correction, based on the definition noted earlier.
Comparatively, if we assume that this current downtrend turns into a genuine stock market correction, it could be our third in roughly 16 months. There's no predicting when stock market corrections will occur, but know that they happen more frequently than you probably realize.
2. Corrections tend to last a relatively short amount of time
The next "must-know" about stock market corrections is that they're generally short-lived. Even though we can't predict how long they'll last (to a T), when they'll start, what causes them, or how steeply the drop will be, data since the 1950s shows them to be relatively short events.
There are a couple of reasons corrections tends not to last all that long. For starters, keep in mind that short-selling (i.e., betting against a stock or equity) involves borrowing money. Having to pay interest to your brokerage to bet against equities makes short-selling considerably costlier than simply buying a stock. As a result, downside bets tend to be of the short-term variety.
Another reason is that moves lower in the market are apt to be driven more by emotion, at least relative to upward swings in stocks. This emotion-driven trading has a propensity to push stocks and the market lower at a rapid rate.
Also, don't overlook the fact that most of the protracted stock market corrections occurred prior to 1984. Since the mid-1980s, and especially the 1990s, television networks devoted to financial news, such as CNBC, and the internet, have transformed the way Wall Street and investors consume news and financial reports. Whereas 50 years ago it was possible for wild rumors to move markets for extended periods of time, that's become highly unlikely today with retail investors having the same access to information on individual stocks and broad-based economic data as professional traders on Wall Street.
3. You're pretty much always a winner if you buy during a correction (as long as you stick around)
The last of the must-knows of stock market corrections is that you'll almost always look like a genius if you buy new stocks, or add to existing positions, during one.
Despite 37 previous corrections in the S&P 500 since the start of 1950, some of which surpassed 30%, 40%, or even 50%, each and every one of these declines has been completely erased by a bull market rally. Sometimes it takes just weeks or a few months to completely recoup all losses, such as what we saw occur at the beginning of 2019, when it took only a few months to erase the roughly 20% decline experienced during the fourth quarter of 2018. Other times, it can take years to soar to new heights, such as the 1973-1974 bear market in the S&P 500 where new highs wouldn't be hit for more than five years in the benchmark index.
The point being that if you buy into a diversified number of high-quality companies (i.e., don't put your eggs in one basket) during a stock market correction or bear market, you're almost assured to come out ahead over the long run. The key being that you have to stick around long enough, and be willing to deal with occasional (but normal) hiccups, to reap the rewards.
In short, while folks panic about potential trade wars on multiple fronts and the inversion of the Treasury yield curve, just know that if you're buying, you're likely to come out smelling like a rose at some point in the future.