What are the characteristics of a correction??
The terms “market correction” or “pullback” are used loosely and can often be misunderstood so we thought it would be a good idea to discuss what happens during a normal market correction. First though, we must start by identifying what a correction is.
The market goes through stages after an upside run where it tends to get overheated or is due to take a break. The buyers are often exhausted, there is little perceived near term upside potential, profit taking occurs, the sellers want their chance, and so on. The reasons are beyond the scope of this post.
A good analogy to use is to think about a car overheating. If for some reason your car is low on freon and you notice that the engine is getting really hot, there a couple of sensible things to do. First, we pull over and let the engine cool off. Secondly, we take care of the problem by either adding Freon and/or fixing where there is a leak. After, we can then resume driving our car as normal.
The same philosophy relates to the market. There are times when the prices of securities get too hot. Typically, this tends to happen when amateur investors rush into the market after seeing it go up for quite some time. These amateurs, or followers, tend to buy at the top and often sell at the bottom i.e., the worst possible times. These are also the people that we hear ranting about how terrible the stock market is, only to be sucked right back in after it makes another run.
So what actually tends to happen during a correction and what characteristics occur?
Typically, certain factors are necessary for a correction to run its course assuming it is indeed a correction within a long term bull market and not the beginning of a bear market.
In the simplest terms a correction is designed to “shake out” investors. Generally speaking it inflicts pain upon the amateur investor to force him or her to sell their investments, driving prices lower. In “herd mentality” when prices are seemingly moving up these amateurs rush in at the top to buy at premium levels only to be forced out when prices temporarily retreat.
Another characteristic is time or duration of the pullback which can be weeks or months. Moreover there typically is a testing and retesting of lower support levels. Put another way, “there is no such thing as a V bottom”. Generally the market makes a low, rallies and then test or pulls back to that low one or more times before running into positive territory.
Finally, the media has the jump on the pullback and advertise it as the next bear market. When you get to the point where you turn on CNBC and your blood pressure starts to increase (more than usual for CNBC standards!!) then you are close to the end of the correction.
The market has a way of tricking even the most sophisticated investor. It makes the professional try to rationalize the irrational and conclude things that are inconcludable. This is why we do not let our opinions get in the way of our investment decisions.
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