As I sit here on my couch on Tuesday evening, Jan. 7, I'm reminded of the fact that the stock market can be a fickle creature in the short term.
Following reports of a missile attack from Iran on an Iraqi airbase that houses American troops, all three major U.S. indexes are "plunging," according to a variety of major news outlets. In fact, I counted four separate news sources that referred to the more than 300-point downward move in the futures of the 123-year-old Dow Jones Industrial Average (^DJI 1.18%) as a "plunge."
However, rarely do the actual moves in major U.S. stock indexes match the imagery expressed in news outlet headlines. With the market reminding investors that it can move in both directions, perhaps now is a good time to brush up on the seven things you should know when the next stock market correction strikes.
Image source: Getty Images.
1. Corrections are wholly unpredictable
The first thing to note is that stock market corrections -- i.e., declines in a major market index of at least 10% -- are completely unpredictable. The fact remains that we'll never know when a correction will start or end, how steep the decline will be, or what will cause it (until after the fact).
Take the escalation between Iran and the U.S. as an example. Tensions between the two nations have been heightened before, but I didn't hear a single Wall Street analyst suggest ahead of time that the death of a top Iranian general would lead to Middle East escalation and stock market unrest. Most stock market corrections wind up coming out of left field, and that's something investors have to learn to accept.
2. They happen more often than you probably realize
You should also be aware that stock market corrections happen a lot more often than you probably realize. Over the past 70 years, the benchmark S&P 500 (^GSPC 1.26%) has undergone 37 corrections of at least 10% (not including rounding), according to data from analytics firm Yardeni Research. That's a double-digit percentage decline every 1.89 years, on average.
If the criteria were expanded a bit to include declines of 6% or more, and include rounding, there have been 13 such declines in the S&P 500 over just the past 10 years. This means, on average, the S&P 500 has seen at least a 6% decline once every 9.2 months over the past decade. In short, stock market corrections are common and inevitable.
Image source: Getty Images.
3. Stock market corrections usually run their course very quickly
Another thing to be aware of is the fact that stock market corrections often find a bottom rather quickly. While the declines associated with a correction can incite panic among investors, 23 of the aforementioned 37 declines in the S&P 500 since the beginning of 1950 have gone from peak to trough in 104 or fewer calendar days. Translation: Corrections can be steep, but a majority are over in just 3.5 months.
It's particularly noteworthy that as technology has brought information to retail investors with the click of a mouse, the average duration of stock market corrections has shrunk considerably. Prior to 1984, 11 of 22 corrections in the S&P 500 lasted between 162 and 622 calendar days. Since 1984, only three of the 15 corrections in the benchmark index have surpassed 104 calendar days.
4. They're typically driven by emotions, rather than fact
This probably goes without saying, but predicting how investors will respond to a stock market correction is just as impossible as forecasting when they'll occur or how steep the decline will be. What we do know, at least historically, is that corrections are usually driven more by emotions than reason.
Just as valuations can extend to the upside, with the "fear of missing out" on the next big investment trend fueling certain industries higher (ahem, blockchain and marijuana), the fear of being caught in a market downdraft can send some traders scurrying to the sidelines, further perpetuating a short-term "plunge" in the market.
Image source: Getty Images.
5. Adjust your focus to percentages, not "points"
One of the absolute most important things to remember about stock market corrections is to view these moves lower in the proper context. This means reading beyond the sensationalized headlines that claim the market is "plunging" and, instead, dig deeper to see how much stocks are really moving. The best way to do this is to ditch following the point-based moves in major U.S. indexes and track their percentage moves instead.
For instance, the "more than 300-point plunge" in the Dow Jones Industrial Average's futures in the evening hours this past Tuesday sounds like a lot, but in reality represents a just over 1% decline in the Index. For context, the 20th-biggest single-session percentage decline in the Dow is 6.91%. In other words, rarely is the stock market actually "plunging," at least the way most media outlets describe it.
6. Staying the course is always your best bet
Perhaps unsurprisingly, the best move you can make during a stock market correction is to stay the course. While it can be tempting to head to the sidelines and wait out the volatility, this often proves a poor decision. An annual analysis from J.P. Morgan Asset Management regularly finds that 50% to 60% of the 10 best single-session performances in the S&P 500 over the trailing 20 years occur within a few weeks of the S&P 500's largest single-session percentage declines. If you head to the sidelines, you'll typically miss out on these big gains.
What's more, the S&P 500 has eventually put all 37 of its previous corrections since 1950 in the rearview mirror. Though the stock market may offer few guarantees, the long-term appreciation of high-quality businesses appears to be one.
Image source: Getty Images.
7. Time-tested dividend stocks are often an excellent downside hedge
Finally, understand that the best way to prepare for a stock market correction is to own an assortment of time-tested dividend stocks. Remember, dividend stocks are almost always profitable and proven businesses, and the payouts you receive can help to partially offset any short-term downside in the stock market.
Take NextEra Energy (NEE 1.87%) as an example. As an electric utility, NextEra is unlikely to see any substantive change in consumption rates among consumers when the next stock market correction strikes. Because NextEra Energy provides a basic-need service, and its traditional electricity operations are regulated by state-level utility commissions (meaning it won't be exposed to wholesale price fluctuations), the company's cash flow is highly predictable. This is why NextEra, and dozens upon dozens of other time-tested dividend stocks, may be perfect to help hedge against a stock market correction.
