A Framework For Thinking About Stock Market Corrections

When actively trading the stock market it's important to have realistic expectations for how stocks and the overall market behave. That’s one of the reason I use Stage Analysis, human emotion and its influence on supply and demand doesn’t change over time, and we see the same pattern (the 4 stages of Stage Analysis) repeat over and over in the market.

When thinking about market corrections I like putting them into 3 buckets, 5%, 10%, and 20+% corrections (a 20+% correction is also commonly referred to as a bear market). The table below shows 10% and 20+% corrections since 1928 (minus the late 2018 correction).

Source: Yardeni Research

The next table shows 5%+ corrections since the March 2009 low. As you can see when you drop to that threshold you get much more frequent activity.

Source. @charliebilello on Twitter

From this data the basic framework I've created for stock market corrections is the following:

• 5% corrections happen almost every year, and we can expect on average 2-3 of them a year.
• 10% corrections can happen once a year every year or every few years.
• 20+% corrections are more rare and the market can go a long time between them, 10+ years in some cases or sometimes just a few years.

So, in general, we should be expecting to see a few 5% corrections a year. Even a 10% correction should basically be expected but should happen fewer than 5% corrections. A 20+% correction is a more rare event that we can expect to have multiple years between.

5% corrections are essentially profit taking events when the market is in Stage 2 and enough selling pressure comes in to bring the market back down to the 30-week MA. The course of action I like to take for 5% corrections is to reduce position sizes, that keeps me exposed to the market but lessens the blow of a market pullback.