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Why Market Corrections Are Not Bad

NASDAQ Stock Market

The Dow Jones Industrial Average (DJI) has gone down nearly 7%, declining almost 2,000 points since it hit its previous high on October 3rd.  The index has declined from 26,793 down to 24,899 in the last 8 days of trading.

Although this loss is significant in the short-term, it could prove to be healthy and necessary in the long term.  This is because right now we’re much closer to being in ‘correction’ territory opposed to ‘crash’ territory.

There is a major difference between a market crash and market correction both in terms of price action and what it means to the market sentiment.  While market crashes signal a change in the market long term, a market correction normally signals a change in direction for the immediate term.

When the market crashes, the sentiment normally is very bearish after.  A crash is defined by a decline of 10% in price in one day.  The market has crashed a few times in history, which was one of the main catalysts of the Great Depression.

On the other hand, market corrections aren’t as scary, and do not leave the economy in shambles.  A market correction is generally defined as a 10% drop in price from an index or stocks previous price.  A correction does not happen in one-day, rather it happens over a few days, weeks, or months.

These market corrections actually happen pretty frequently, but do not tend to last long.  Deutsche Bank stated that the stock market corrects every 357 days, on average.  Between 1945 and 2013, the average correction on the Dow lasted only 71 trading days.

Corrections are caused by a mixture of variables, but you can boil it down to two factors: analysis and emotion.  On the fundamental side, the market tends to follow variables such as earnings.  When corporations are posting positive earnings and are growing, the market will follow.  A large part of the market also relies on technical analysis, using trend lines and indicators to predict future price action.  Recently indexes across the market were hitting all-time-highs which may trigger a sell-off for technical traders.

Additionally, the market is largely dictated by emotion.  Fear and greed rule the market and affect the trading decision of just about every trader.  For example, if someone is up significantly on a position, greed may cause them to hold longer.  On the other hand, fear may come in to play causing the trader to sell their position.  When traders see others selling it can often cause a snowball affect fueled by fear and uncertainty.




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