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The Anatomy of a Stock Market Correction

By Jordan Wathen – Jan 20, 2016 at 7:21PM

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How stock market corrections happen and why a downturn affects stocks differently.

A stock market correction happens when the stock market declines by 10% from its most recent peak. The S&P 500 Index (^GSPC 3.10%)is down about 9.9% year to date to start 2016, and down about 11.5% since its most recent peak on Dec. 29, 2015.

The current market rout is, by definition, a stock market correction.

What triggers a correction?
Sell-offs in the stock market are usually the result of worries about the future. Today, it's everything from low oil prices to the fact that the Industrial Production Index may be forecasting a future recession.

As is often the case, though, the stock market tends to be very wrong at predicting the future. As my colleague, Morgan Housel, has pointed out, stock market corrections of 10% happen just about every 11 months. Recessions happen far less frequently than that.

There are also the technical issues that affect stock prices. One of out of every three dollars in stock funds now tracks an index. Thus, daily buying and selling is often driven by "brainless" index funds, which have to buy or sell to match an index as clients add or withdraw money. This buying or selling can make stocks more volatile, as funds sell on the way down and buy on the way up.

Looking inside a correction
Not all stocks are hit equally in a correction. Since the start of 2016, defensive stocks have performed relatively well. Riskier and cyclical stocks are taking a beating.

The S&P 500 Index is made up of roughly 500 stocks, which can be grouped into 10 sectors. By breaking the S&P 500 index into "sectors," we can look into the eye of the storm and see how different industries respond in a stock market correction.

Note that while every sector has lost value in 2016, the best-performing sectors are utilities and consumer staples stocks. That's typically what happens in a correction -- investors turn to safe havens, knowing that people will still want electricity and shampoo, regardless of the economic or stock market environment. Utilities and consumer staples stocks also tend to offer higher dividend yields, which investors embrace when stocks fall.

On the other hand, energy and materials stocks -- industries that are simply getting crushed by low commodity prices -- are among the worst performing. Not only are commodity prices currently low, but if investors fear an economic slowdown, they also have to consider that lower demand in the future will result in even lower commodity prices.

Financial services companies, whose earnings generally rise and fall with stock prices and the health of the market, are also hard hit during stock market corrections. 

The important lesson here is diversification. Investors who stuffed their portfolios with oil stocks are experiencing a vastly different stock market than investors who have a portfolio of utility stocks. The diversified investor who owns the S&P 500 index in its entirety has experienced a 10% loss this year -- not great but hardly life-changing.

Corrections are a time machine
Before freaking out, put the stock market correction in perspective. Corrections are an excellent opportunity to buy stocks at lower prices.

If you missed out on rising stock prices since 2009, you now have an opportunity to go back in time and buy stocks at prices not seen since Jan. 2014. That's the beauty of a correction -- all the stocks you wished you owned just months ago are now available at average prices not seen in over two years.

Take the long view: Over periods spanning years, the stock market is the single greatest wealth creator ever seen. You just have to be willing and able to tolerate a 10% drop from time to time. That's a very small price to pay for the historical rewards of being a buy-and-hold stock investor.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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