Making Sense Of Market Correction

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Making Sense Of Market Anomalies

In the non-investing world, an anomaly is a strange or unusual occurrence. In financial markets, anomalies refer to situations when a security or group of securities performs contrary to the notion of efficient markets, where security prices are said to reflect all available information at any point in time.

With the constant release and rapid dissemination of new information, sometimes efficient markets are hard to achieve and even more difficult to maintain. There are many market anomalies; some occur once and disappear, while others are continuously observed. (To learn more about efficient markets, see What Is Market Efficiency?)

Can anyone profit from such strange behavior? We’ll look at some popular recurring anomalies and examine whether any attempt to exploit them could be worthwhile.

Calendar Effects
Anomalies that are linked to a particular time are called calendar effects. Some of the most popular calendar effects include the weekend effect, the turn-of-the-month effect, the turn-of-the-year effect and the January effect.

  • Weekend Effect: The weekend effect describes the tendency of stock prices to decrease on Mondays, meaning that closing prices on Monday are lower than closing prices on the previous Friday. For some unknown reason, returns on Mondays have been consistently lower than every other day of the week. In fact, Monday is the only weekday with a negative average rate of return.
    YearsMondayTuesdayWednesdayThursdayFriday1950-2004-0.072%0.032%0.089%0.041%0.080%Source: Fundamentals of Investments, McGraw Hill, 2006
  • Turn-of-the-Month Effect: The turn-of-the-month effect refers to the tendency of stock prices to rise on the last trading day of the month and the first three trading days of the next month.
    YearsTurn of the MonthRest of Days1962-20040.138%0.024%Source: Fundamentals of Investments, McGraw Hill, 2006
  • Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased trading volume and higher stock prices in the last week of December and the first two weeks of January.
    YearsTurn of the YearRest of Days1950-20040.144%0.039%Source: Fundamentals of Investments, McGraw Hill, 2006
  • January Effect: Amid the turn-of-the-year market optimism, there is one class of securities that consistently outperforms the rest. Small-company stocks outperform the market and other asset classes during the first two to three weeks of January. This phenomenon is referred to as the January effect. (Keep reading about this effect in January Effect Revives Battered Stocks.) Occasionally, the turn-of-the-year effect and the January effect may be addressed as the same trend, because much of the January effect can be attributed to the returns of small-company stocks.

Why Do Calendar Effects Occur?
So, what’s with Mondays? Why are turning days better than any other days? It has been jokingly suggested that people are happier heading into the weekend and not so happy heading back to work on Mondays, but there is no universally accepted reason for the negative returns on Mondays.

Unfortunately, this is the case for many calendar anomalies. The January effect may have the most valid explanation. It is often attributed to the turn of the tax calendar; investors sell off stocks at year’s end to cash in gains and sell losing stocks to offset their gains for tax purposes. Once the New Year begins, there is a rush back into the market and particularly into small-cap stocks.

Announcements and Anomalies
Not all anomalies are related to the time of week, month or year. Some are linked to the announcement of information regarding stock splits, earnings, and mergers and acquisitions.

  • Stock Split Effect:Stock splits increase the number of shares outstanding and decrease the value of each outstanding share, with a net effect of zero on the company’s market capitalization. However, before and after a company announces a stock split, the stock price normally rises. The increase in price is known as the stock split effect. M
    any companies issue stock splits when their stock has risen to a price that may be too expensive for the average investor. As such, stock splits are often viewed by investors as a signal that the company’s stock will continue to rise. Empirical evidence suggests that the signal is correct. (For related reading, see Understanding Stock Splits.)
  • Short-Term Price Drift: After announcements, stock prices react and often continue to move in the same direction. For example, if a positive earnings surprise is announced, the stock price may immediately move higher. Short-term price drift occurs when stock price movements related to the announcement continue long after the announcement. Short-term price drift occurs because information may not be immediately reflected in the stock’s price.
  • Merger Arbitrage: When companies announce a merger or acquisition, the value of the company being acquired tends to rise while the value of the bidding firm tends to fall. Merger arbitrage plays on potential mispricing after the announcement of a merger or acquisition. The bid submitted for an acquisition may not be an accurate reflection of the target firm’s intrinsic value; this represents the market anomaly that arbitrageurs aim to exploit. Arbitrageurs aim to take advantage of the pattern that bidders usually offer premium rates to purchase target firms. (To read more about M&As, see The Merger – What To Do When Companies Converge and Biggest Merger and Acquisition Disasters.)

Superstitious Indicators
Aside from anomalies, there are some nonmarket signals that some people believe will accurately indicate the direction of the market. Here is a short list of superstitious market indicators:

  • The Super Bowl Indicator: When a team from the old American Football League wins the game, the market will close lower for the year. When an old National Football League team wins, the market will end the year higher. Silly as it may seem, the Super Bowl indicator was correct more than 80% of the time over a 40-year period ending in 2008 . However, the indicator has one limitation: It contains no allowance for an expansion-team victory.
  • The Hemline Indicator: The market rises and falls with the length of skirts. Sometimes this indicator is referred to as the “bare knees, bull market” theory. To its merit, the hemline indicator was accurate in 1987, when designers switched from miniskirts to floor-length skirts just before the market crashed. A similar change also took place in 1929, but many argue as to which came first, the crash or the hemline shifts.
  • The Aspirin Indicator: Stock prices and aspirin production are inversely related. This indicator suggests that when the market is rising, fewer people need aspirin to heal market-induced headaches. Lower aspirin sales should indicate a rising market. (See more superstitious anomalies at World’s Wackiest Stock Indicators.)

Why Do Anomalies Persist?
These effects are called anomalies for a reason: they should not occur and they definitely should not persist. No one knows exactly why anomalies happen. People have offered several different opinions, but many of the anomalies have no conclusive explanations. There seems to be a chicken-or-the-egg scenario with them too – which came first is highly debatable.

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Profiting From Anomalies
It is highly unlikely that anyone could consistently profit from exploiting anomalies. The first problem lies in the need for history to repeat itself. Second, even if the anomalies recurred like clockwork, once trading costs and taxes are taken into account, profits could dwindle or disappear. Finally, any returns will have to be risk-adjusted to determine whether trading on the anomaly allowed an investor to beat the market. (To learn much more about efficient markets, read Working Through The Efficient Market Hypothesis.)

Anomalies reflect inefficiency within markets. Some anomalies occur once and disappear, while others occur repeatedly. History is no predictor of future performance, so you should not expect every Monday to be disastrous and every January to be great, but there also will be days that will “prove” these anomalies true!


What Is a Correction?

In investing, a correction is a decline of 10% or more in the price of a security from its most recent peak. Corrections can happen to individual assets, like an individual stock or bond, or to an index measuring a group of assets.

An asset, index, or market may fall into a correction either briefly or for sustained periods—days, weeks, months, or even longer. However, the average market correction is short-lived and lasts anywhere between three and four months.

Investors, traders, and analysts use charting methods to predict and track corrections. Many factors can trigger a correction. From a large-scale macroeconomic shift to problems in a single company’s management plan, the reasons behind a correction are as varied as the stocks, indexes, or markets they affect.

How a Correction Works

Corrections are like that spider under your bed. You know it’s there, lurking, but don’t know when it will make its next appearance. While you might lose sleep over that spider, you shouldn’t lose sleep over the possibility of a correction.

According to a 2020 CNBC report, the average correction for the S&P 500 lasted only four months and values fell around 13% before recovering. However, it is easy to see why the individual or novice investor may worry about a 10% or greater downward adjustment to the value of their portfolio assets during a correction. They didn’t see it coming and don’t know how long the correction will last. For most investors, in the market for the long term, a correction is only a small pothole on the road to retirement savings. The market will eventually recover, so, they should not panic.

Of course, a dramatic correction that occurs in the course of one trading session can be disastrous for a short-term or day trader and those traders who are extremely leveraged. These traders could see significant losses during times of corrections.

No one can pinpoint when a correction will start, end, or tell how drastic of a drop prices will take until after it’s over. What analysts and investors can do is look at the data of past corrections and plan accordingly.

Key Takeaways

  • A correction is a decline of 10% or greater in the price of a security, asset, or a financial market.
  • Corrections can last anywhere from days to months, or even longer.
  • While damaging in the short term, a correction can be healthy, adjusting overvalued asset prices and providing buying opportunities.

Charting a Correction

Corrections can sometimes be projected using market analysis, and by comparing one market index to another. Using this method an analyst may discover that an underperforming index may be followed closely by a similar index that is also underperforming. A steady trend of these similarities may be a sign that a market correction is imminent.

Technical analysis review price support and resistance levels to help predict when a reversal or consolidation may turn into a correction. Technical corrections happen when an asset or the entire market gets overinflated. Analysts use charting to track the changes over time in an asset, index, or market. Some of the tools they use include the use of Bollinger Bands, envelope channels, and trendlines to determine where to expect price support and resistance.

Preparing Investments for a Correction

Before a market correction, individual stocks may be strong or even overperforming. During a correction period, individual assets frequently perform poorly due to adverse market conditions. Corrections can create an ideal time to buy high-value assets at discounted prices. However, investors must still weigh the risks involved with purchases, as they could well see a further decline as the correction continues.

Protecting investments against corrections can be difficult, but doable. To deal with declining equity prices, investors can set stop-loss orders or stop-limit orders. The former is automatically triggered when a price hits a level pre-set by the investor. However, the transaction may not get executed at that price level if prices are falling fast. The second stop order sets both a specified target price and an outside limit price for the trade. Stop-loss guarantees execution where stop-limit guarantees price. Stop orders should be regularly monitored, to ensure they reflect current market situations and true asset values. Also, many brokers will allow stop orders to expire after a period.

Investing During a Correction

While a correction can affect all equities, it often hits some equities harder than others. Smaller-cap, high-growth stocks in volatile sectors, like technology, tend to react the strongest. Other sectors are more buffered. Consumer staples stocks, for example, tend to be business cycle-proof, as they involve the production or retailing of necessities. So if a correction is caused by, or deepens into, an economic downturn, these stocks still perform.

Diversification also offers protection—if it involves assets that perform in opposition to those being corrected, or those that are influenced by different factors. Bonds and income-vehicles have traditionally been a counterweight to equities, for example. Real or tangible assets, like commodities or real estate—are another option to financial assets like stocks.

Although market corrections can be challenging, and a 10% drop may significantly hurt many investment portfolios, corrections are sometimes considered healthy for both the market and for investors. For the market, corrections can help to readjust and recalibrate asset valuations that may have become unsustainably high. For investors, corrections can provide both the opportunity to take advantage of discounted asset prices as well as to learn valuable lessons on how rapidly market environments can change.

Creates buying opportunities into high-value stocks

Can be mitigated by stop-loss/limit orders

Calms over-inflated markets

Can lead to panic, overselling

Harms short-term investors, leveraged traders

Can turn into prolonged decline

Real-World Examples of a Correction

Market corrections occur relatively often. Between 1980 and 2020, the U.S. markets experienced 37 corrections. During this time, the S&P 500 fell an average of 15.6%. Ten of these corrections resulted in bear markets, which are generally indicators of economic downturns. The others remained or transitioned back into bull markets, which are usually indicators of economic growth and stability.

Take the year 2020, for example. In February 2020, two major indexes, the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500) index, both experienced corrections, dropping by more than 10%. Both the Nasdaq and the S&P 500 also experienced corrections in late October 2020.

Each time, the markets rebounded. Then another correction occurred Dec. 17, 2020, and both the DJIA and the S&P 500 dropped over 10%—the S&P 500 fell 15% from its all-time high. Declines continued into early January with predictions that the U.S. had finally ended a bear market abounding.

The markets began to rally, erasing all the year’s losses by the end of January. As of mid-April 2020, the S&P 500 was up about 20% since the dark days of December. Optimistic analysts are saying the bull market still has legs to run, though a few pessimists fear the upswing could be a short-lived bear market rally—or to use another animal metaphor a dead cat bounce.

How Often Is Buying Into a Stock Market Correction a Bad Idea?

You’ll be surprised by the answer.

Chances are that if you’re invested in the stock market, you don’t need a reminder of how challenging the past month has been. After hitting an all-time closing high on May 3, the broad-based S&P 500 (SNPINDEX:^GSPC) has proceeded to lose about 7% of its value, through June 3. In fact, the 6.6% loss registered by the market’s benchmark index last month was the second worst on record in May since the 1960s.

Right now, pretty much everything, save for the kitchen sink, has Wall Street on edge. There’s the possibility of the U.S. fighting a trade war on two fronts (with China and Mexico). Also, since November, Treasury yields have been on a precipitous decline, with the yield curve pushing to its largest inversion since 2007. Since bond prices and bond yields move in opposite directions, this action is indicative of significant bond-buying and equity aversion.

Image source: Getty Images.

There are concerns on the earnings front, too. The latest “Earnings Insight” report from FactSet Research Systems, dated May 31, finds that blended earnings growth for the 98% of S&P 500 companies to have reported their first-quarter operating results is minus 0.4%. If this negative number holds true, it’ll mark the first year-over-year earnings decline for the index since the second quarter of 2020.

Suffice it to say, market uneasiness has investors questioning whether they should be buying into this latest stock market correction.

Is there ever a bad time to buy into a stock market correction?

That raises the question: Is there a time when buying a significant dip in the stock market isn’t a good idea?

To answer this, I relied on data provided by stock market analytics firm Yardeni Research on the S&P 500. Here’s what I found.

Since 1950, the S&P 500 has undergone 37 “true” stock market corrections, equating to a decline of at least 10%, not including rounding. If we also count notable declines of near 10%, but not officially a “correction” in the traditional sense of the term, this figure inches up to 47 reasonably sizable declines in the S&P 500 since 1950. or 48 if you want to include the existing 7% drop in the benchmark index through June 3.

Image source: Getty Images.

Yet, here’s the interesting thing: Despite the fact that investors have no clue what will cause a correction, when one will start, how steep the drop will be, or when that drop will end, it’s always been a smart idea to buy the dips in the S&P 500. And I don’t mean “always” in that exaggerated sense. I literally mean always. No matter when you bought into the S&P 500 during any one of its previous 37 stock market corrections, or even its 10 notable declines that didn’t quite qualify as a correction, you’d have eventually made money — the only exception being that you had to hold onto your investment long enough to realize the rewards. Sometimes it took just weeks for corrections to be completely put into the rearview mirror, while on other occasions it took years. But the point is, markets head higher over the long run.

To put this into even more glaring terms, since May 3, there have been 30 calendar days where investors who bought into the S&P 500 would have been down on their investment (based on closing values for the index). Compare that with the 25,324 calendar days that investors could have bought into the S&P 500 prior to May 3 (including leap days. I didn’t forget!) and still have been up on their initial investment.

When the stock market declines, it’s a roll-out-the-red-carpet buying opportunity for investors.

These top-tier stocks could be worth buying

With this is mind, here are a few high-quality stocks you might consider adding to or gobbling up as the stock market inches closer to correction territory.

Image source: Getty Images.

Bristol-Myers Squibb

One idea is pharmaceutical giant Bristol-Myers Squibb (NYSE:BMY) , which is a stone’s throw away from hitting a nearly six-year low. Bristol-Myers has two highly successful pharma franchises in treating cancer and providing anticoagulants. Superstar cancer immunotherapy Opdivo looks to be well on its way to perhaps $7 billion-plus in annual sales in 2020, with blood-thinner Eliquis, which was developed in cooperation with Pfizer, on pace for nearly $8 billion in annual sales. These two high-growth therapies make up close to two-thirds of Bristol-Myers’ revenue.

In addition to solid existing franchises, Bristol-Myers is acquiring Celgene for $50 in cash, plus one share of its own stock, for each share of Celgene. In return, Bristol will get its hands on multiple myeloma drug Revlimid, which has been consistently growing sales at 15% to 20% per year, and may soon become the best-selling drug in the world, on an annual basis.

Keeping in mind that a falling stock market has absolutely no bearing on what sort of ailments people develop, this recent dip in Bristol-Myers’ stock makes little sense. Once we tack on a 3.6% yield, the idea of buying into weakness becomes all the more palatable.

Image source: Getty Images.


Another real head-scratcher is the idea that a modest decline in the stock market is going to be somehow bad for telecom and content services giant AT&T (NYSE:T) .

AT&T should benefit from two pretty significant catalysts in the years to come. First, there’s the completion of its Time Warner buyout, giving it access to the CNN, TNT, and TBS networks. These networks are popular bargaining chips and dangling carrots that AT&T can use to lure streaming subscribers away from its competitors, as well as boost its advertising pricing power.

Beyond its media networks, AT&T also stands to benefit from the rollout of 5G networks across the United States. Consumers’ thirst for data consumption should push a new wave of smartphone upgrades, leading to an even greater amount of data being used. Since the majority of AT&T’s wireless margins are from the data side of the equation, this couldn’t be better news for the company.

While earnings growth could certainly be more impressive, just remember that there’s a 6.7% dividend yield backing this stock, which is more than triple what you’d net by investing in Treasury bonds. In other words, there’s ample incentive to stick around and let AT&T make you money.

Image source: Getty Images.

Philip Morris International

Buying into tobacco stock Philip Morris International (NYSE:PM) following its recent weakness might also make sense.

It’s understandable why investors are skeptical of tobacco stocks, given that adult cigarette smoking rates in the U.S. hit an all-time low in 2020 of roughly 14%. Pessimists view this decline as a trend among developed nations, which is why Philip Morris has had a bumpier ride than normal of late.

But what investors might be overlooking is that Philip Morris doesn’t operate only in the United States; it has operations in more than 180 countries worldwide. This geographic breadth protects it from more stringent tobacco laws in a small handful of developed countries where it operates. All the while, burgeoning middle classes in China and India remain key sources of long-term growth for its tobacco operations.

The company also has its eye on sustainable growth with its IQOS heated tobacco device, which allows users to receive nicotine without inhaling a number of other harsh chemicals found in smokable tobacco products. IQOS’ rollout has just begun, and the company is actively looking at other tobacco alternatives to spur growth.

With a nearly 6% dividend yield and plenty of pricing power, Philip Morris is the perfect stock to consider buying during this correction.

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