4 Tips for Navigating a Stock Market Correction

Since the arrival of COVID-19, the U.S. public equity market has suffered several market corrections. Understandably, investors may be spooked because a bear market typically follows market corrections. In addition, with talks of a recession right around the corner, the public equity market seems like a problematic sea to sail.

This article will provide a clear picture of market corrections, why they occur, what it means for the public equity market, and how investors can better understand (and even benefit) from a bear market.

Stock Market Corrections: What Are They and How are They Used?

According to Forbes Advisor, a stock market correction is “a sustained decline in the value of a market index or the price of an individual asset. A correction is generally agreed to be a 10-20% drop in value from a recent peak. Correction can happen to the S&P 500, a commodity index, or even shares of your favorite tech company.”

Market corrections can occur for a variety of reasons. At first glance, market corrections imply several things: investors are more motivated to sell than to buy, there is a shrinking or slowing economy, a lack of trade momentum, or a ‘black swan’ even like COVID-19, Russian-Ukraine war, or global supply chain constraints. When some or all of these occur, stocks previously traded based on their local ‘supply and demand’ level tend to return to baseline. For example, fewer investors purchase once considered ‘high-demand’ stock, driving the stock ‘supply’ back to equilibrium. As a result, companies with falling stock are at greater risk of being purchased at a lower market valuation.

What Events Led to the Current Market Correction?

The beginning of the COVID-19 pandemic saw the market plunge in response to changing and hard-to-predict economic landscape, followed by a meteoric rise to an all-time high on the S&P 500 and Dow Jones in early January 2022. Since then, it has been going in and out of bear market territory.

In August 2022, the U.S. saw its most significant inflation increase in 40 years, to a troubling 8.9%. Although the inflation rate declined to 6.5% in December 2022, the effects are still being felt by consumers and investors. Prices have continued to rise, and salaries have failed to keep up with inflation despite a strong employee marketing. As a result, individuals and organizations are changing their consuming and saving habits.

Stimulus plans from the Trump and Biden administrations poured new money into the markets through 2020 and 2021. The influx of cash gave rise to an uptick in consumption, including stock purchases, making the market surge to an all-time high in an otherwise fragile economy. Because people were purchasing more, companies had to navigate unprecedented demand while encountering worldwide supply chain bottlenecks. These bottlenecks made company performance more volatile, leaving investors unsure whether to buy or hold positions in them.

Between an increase in individual spending, heightened consumer demand, an ambitious stock market, rising inflation, and a slowing economy, the market could no longer sustain itself. And thus, private equity companies must now contend with a less welcoming market.

What This Means for the Public Equity Market

When a market correction occurs, one of two things can happen: either the market stabilizes itself and returns to its growth trajectory, or it continues to fall and enters what is known as a bear market. A bear market can be defined as “a market decline of more than 20% from a recent all-time high.” For example, since its peak in January 2022, the S&P 500 has entered bear market territory falling by 23% in late September 2022.

Today, the current bear market symptoms do not bode well for stock investors. The recent interest rate increases by the U.S. Federal government may contribute to a recession. As a result of higher interest rates, companies will be less likely to borrow money for debt payments or growth strategies, making stock market performance more volatile.

In particular, over-valuated companies will be some of the biggest losers due to market correction. For example, tech companies like Amazon, Alphabet (Google’s parent company), and Tesla experienced significant hits to their stock prices, losing value by 35%, 24%, and 37%, respectively. Unfortunately, this also resulted in widespread layoffs across the tech industry, with over 66,000 layoffs occurring in January 2023 alone.

Currently, investors have reason to be wary. With the recent interest rate increases, an economic decline looms. For example, at the time of writing, the average 30-year mortgage interest rate is 6.4% – up nearly 3.55% since February 2022, which signifies a likely decline in real estate sales. As a result, investors will become more risk averse, likely purchasing fewer stocks or selling more stocks to gain quick access to capital. However, it’s also important to note that the ‘winners’ of the bear market will be more profitable companies with valuations independent of the stock market.

However, despite the seeming doom and gloom of a market recession, there is good news. Historically, stocks return to a positive trajectory after a market correction or a bear market. The typical lifecycle of a market correction is four months, whereas a bear market is 359 days on average. This trend means that though times are not the best for public equity investors, the market will eventually bottom-out, and the uptrend cycle will begin again.

How Can Companies and Investors Leverage the Current Market Status?

The next step to surviving and thriving in a market correction is to not panic. Companies and investors shouldn’t sell on the spot as soon as prices drop. Here are four tips public equity investors should consider when navigating a market correction.

1. Treat Dollar Cost-Averaging as Your Friend

This practice consists of investing the same amount of money in target security at regular intervals over a certain period, regardless of the securities price. This practice aims to lower the share’s average cost and reduce the volatility’s impact on a given portfolio.

2. Buy More Shares

Market corrections also present opportunities for investors to buy more shares of a given index or a range of different stocks at a lower market price. This practice is known as averaging down. As a result, the lower initial cost of the investment will make up for any loss once the financial market recovers, giving investors a winning yield.

3. Go Short

Another riskier option is to leverage market correction for public equity gains by going short on an entire index fund or individual stocks that appeal to investors. Since a correction is happening, these indexes or stocks will lose value. And because the market is bearish, said funds or stocks might continue to fall. Spread bets and CFDs (contracts for difference) are some of the best ways to short the market and leverage a market correction because spread bets and CFDs can be used without investors having to sell their existing share investments. As mentioned, shares will lose value in market corrections as the market declines from its previous peak.

These two financial derivatives also hedge investors’ exposure to risk while keeping investment positions open. The future gains that might come from short positions offset the risk of loss on investments until the market recovers and develop a new upward trend.

4. Opt for the Safe Bet

Leveraging a market correction can provide investors with financial benefits in an otherwise poor economic landscape – but they don’t come without risk. There is always the possibility of a correction turning into a bear market, leading to further price decreases. So always know your risk tolerance before engaging in these practices.

For more risk-averse investors, making profits during these times is critical. Having a well-diversified portfolio and turning away from high-yield, high-rise stocks such as technology for more stable ones like consumer staples of value stocks to hedge some risk.

Market Corrections Create Opportunities For Well-Positioned Investors

The last few years have proven to be difficult for investors and companies alike. Understanding market corrections, how they happen, and what to do when they occur can prove a vital practice to keep afloat during difficult economic times. In addition, market corrections can help investors better understand their portfolio composition, what the real risk of a given stock is if they were overvalued, which stock performs best during tough market times, and, all in all, help their investment strategy become more robust in the long run.

Market corrections are also an opportunity for those willing to take the risk to be able to leverage different types of securities for an eventual profit, buy good-performing overall stocks at a low average price, and come out of a losing situation on the winning side of the market.