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Market correction refers to a temporary reversal of an upward trend in security prices. Market corrections typically involve a drop of between 10 to 20 percent in security prices. Such declines are temporary secondary trends that are exhibited within a larger upward trend in security prices. Every asset class, including stocks, currencies, commodities, and real estate, has been subject to periodic episodes of corrections. History shows that a 20 percent correction occurs once every five years in the stock market.
The phenomenon of a correction can be understood better within a theoretical framework of an equilibrium asset pricing model. The prediction of a multifactor asset pricing model is:
µ = λ0 + BλK
where µ is a vector of expected returns to N securities, λ0 is the risk-free parameter, B is a vector of factor sensitivities, and λK is a (K × 1) vector of factor risk premia. The equilibrium model predicts that changes in expected returns occur in response to changes in the risk-free rate, or in factor premia. An increase in expected return should lead to a drop in prices, which is, in turn, reflected as a market correction.
Some of these theoretical predictions are upheld by the data. It is now well accepted that most market corrections are preceded by a sharp jump in short-term interest rates. An increase in the risk-free rate of interest is predicted by theory to increase the expected return, and hence to lead to a drop in current prices. Market corrections have also been driven by a decline in earnings momentum. The decline in earnings momentum leads investors to revise downward their expectation of future profitability. This, in turn, leads to a drop in current stock prices.
Revised beliefs about economic conditions, however, only partially explain why corrections occur. In a challenge to rational asset pricing models, fear and greed have been advanced as explanations for market corrections. It is believed that market corrections curb excessive investor optimism, also labeled as greed. Fear of further market declines keeps markets down thereafter. The situation reverses when rational investors step in to exploit the buying opportunity created by price drops. Proponents of this irrational behavior offer the short-lived nature of a typical correction as evidence to bolster their view. The average length of a market correction over the period from 1872 to 2004 has been about twelve months. Security prices return to their precorrection levels after this period and, in fact, continue to trend upward thereafter. Such a reversal is inconsistent with a theoretical asset pricing model since the underlying economic conditions that may warrant a market correction do not experience a similar reversal.
Whatever processes underlie a market correction, investors can expect to experience steep drops in security prices periodically. They should also expect every asset category to experience such corrections. Globalization of financial markets has meant that international markets are also not immune to such corrections. Emerging markets experienced a steep market correction of greater than 20 percent during May to June of 2006. Higher volatility in emerging markets makes them more susceptible to frequent market corrections.
Experienced investors are able to weather market corrections with appropriate risk management strategies, the simplest of which is diversification. Diversification across different asset categories protects an investor from steep drops in any one market. Diversification also imposes the discipline of reallocating a portfolio to restore optimal allocations to beaten down sectors of the market. It is these buying activities that have enabled markets to recover soon after a sharp correction.
- Chordia, T., and Shivakumar. 2006. Earnings and Price Momentum. Journal of Financial Economics 80 (3): 627–656.
- Cochrane, John 2005. Asset Pricing. 2nd ed. Princeton, NJ, and Oxford: Princeton University Press.
- Fama, , and K. French. 2002. The Equity Premium. Journal of Finance 57 (2): 637–659.
- Selengut, 2005. Dealing with Market Corrections. Risk Management. 52 (12): 48.
- Shefrin, H 2005. A Behavioral Approach to Asset Pricing. Amsterdam and Boston: Elsevier.
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