The markets have rebounded in 2023, remaining resilient despite high inflation, elevated interest rates, bank failures, and a tepid economy. The S&P 500 is up about 16% year to date (YTD), while the Nasdaq Composite has gained around 33%.
Most predictions have been off this year, as many were calling for a recession and a flat stock market. Where it goes from here is anyone's guess, but the potential is always there for a market correction. Fortunately, there are some bedrock principles you can follow that can guide you through whatever short-term volatility comes at you -- including another market correction.
What causes a market correction?
You've probably heard the terms correction, crash, and bear market thrown around, and all indicate a declining stock market. A correction is a slump of at least 10% and less than 20% over any given time period. A crash is typically an abrupt and dramatic drop, usually more than 10%, but over a very short period, while a bear market -- like we saw in 2022 -- is a decline of more than 20% that lasts several months or longer.
Corrections don't always lead to bear markets. In fact, they usually don't. Often, corrections come on quickly and leave just as rapidly as the market recovers.
Corrections can have many causes, but one of the main ones is that the market has become overvalued. We saw this in 2021 when stocks had become so overvalued that the bubble burst and caused a correction. That correction turned into a bear market as other factors, like inflation, supply chain issues, and geopolitical strife, contributed to a longer period of market decline.
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One way to identify an overvalued market is by looking at the price-to-earnings (P/E) ratio of the S&P 500. It is currently at around 20 for the trailing 12 months, while the forward P/E ratio for the next 12 months is about the same. These valuations are within normal ranges, so the market doesn't appear to be overvalued right now. Another indicator is the Fear and Greed Index, which seeks to gauge investor sentiment. Right now, it is in neutral territory, which indicates the market is fairly priced.
Of course, macroeconomic factors that slow economic growth and impact earnings -- like high inflation, high interest rates, supply chain issues, high unemployment, and a drop in consumer spending, among others -- can lead to a correction, too.
While it is important to try and identify the conditions that could cause the market to drop 10% or more, it is more important to react appropriately and build a portfolio that minimizes the impact.
A strategic approach to corrections
The first thing to know from a long-term investing perspective is that corrections are temporary and often fleeting. Most often, such events are no cause to panic sell. To emphasize again, the focus should always be on the long term. So when building your portfolio, you want to invest in great businesses at good values with track records of consistent earnings and revenue growth, and distinct advantages that give them an edge in their markets. But you also want a diversified portfolio of stocks that don't all perform similarly in a given market.
So along with some aggressive growth stocks, say from the technology sector, you would also want some exposure to large-cap value stocks, which tend to perform better when the larger market is down. This type of strategic diversification will help offset some losses in your portfolio during a correction. You can also diversify with stocks from different industries, or of different market cap sizes, that provide some yin to the others' yang.
For some guidance, you only need to go back to 2022 and look for stocks that had positive returns in a year where the Nasdaq Composite was down 33%.
Now, there are extreme circumstances where a correction may be a time to sell. Just this year, we saw the banking industry crater when three major banks failed. The vast majority of banks, especially large banks, got through it fine, but the entire industry suffered a correction as many investors were panic selling. However, while most banks were in good shape, some regional banks were materially impacted to the extent that a sell might be warranted.
Rather than panic selling, one of the best things you can do in a market correction is buy. When the market drops so sharply and suddenly, there often is a lot of panic selling that is not based on long-term fundamentals. That leaves a lot of great companies available to smart investors at cheaper prices.
So while you can't control market corrections, you can prepare to navigate them -- and even take advantage of them.
