Weekly Update

Different Types of Market Corrections

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Published July 23, 2021


We thought a recent article by David Keller on the various types of market corrections might be of interest. Here it is with some recast charts we provide to assist:

“As the S&P 500 and Nasdaq 100 indexes have pounded away at new all-time highs basically every month in 2021, investors are left to wonder when a correction may actually be coming. We were taught that markets do not just go straight up, but instead they move in a series of impulse moves and corrective reactions as the overall trend continues. But 2021 has very much been the exception to that rule of market trends!

Underneath the hood, however, the picture has indeed been evolving. As the S&P pushed up to new highs in late June into July, the advance-decline lines for the NYSE, as well as the small cap index, did not confirm those new highs (see circled areas in the chart below).

S&P pushed up to new highs in late June into July

This week, we saw further downside confirmation when both of those A-D lines broke below their 50-day moving averages and made new swing lows. This suggests a sort of “stealth correction” where the major averages are moving higher but the conditions underlying that uptrend are much more corrective.

Markets can correct in three ways: a price correction, a time correction and a stealth correction. Let’s briefly review each of these corrective patterns using the chart of the S&P 500 index.

I should note that, while many media outlets like to use specific percentage moves to define a pullback vs. correction vs. bear market, I tend to feel the trend, momentum and support/resistance levels are much more important than the percentage change label. I tend to classify a smaller downturn as a pullback, a deeper downturn as a correction, and a complete rotation to risk-off as a bear market!

February-March 2020 (below) provides a good example of a price correction. The S&P lost about 35% of its value in just over one month. Remember how quickly the market reverted back to the upside, giving the chart its classic V shape? That is what a price correction often looks like.

Price Correction

By mid-April, the S&P was back in uptrend mode, making higher highs and higher lows. The higher April low was a key indication that the price correction was over and the bull phase had resumed.

For a time correction, check out September-October 2020 in the box below. You can see that the market only pulled back about 10%. It was a shallower and wider correction than in February-March. A time correction involves less pain in price but tends to be longer and more drawn out. Time corrections are when the market essentially goes sideways, trading back and forth around an equilibrium price.

Time Correction

Finally, we have a stealth correction, which I would argue we have been in for a while now. While the indexes move higher, many stocks and groups are already breaking down. Stocks that break out often fail, indicating a lack of willing buyers to push prices onward and ever upward. Stealth corrections are tricky because many stocks are still going higher, which can create a sense of overconfidence for investors who believe the market can go only one direction: up.

Below, I look at the ratio of high beta to low volatility stocks (using the SPHB and SPLV ETFs). Note that since mid-February this ratio has essentially been rangebound until this month. This illustrates how the markets have truly been in leadership rotation mode, with offense and defense-oriented sectors taking turns in the driver’s seat – until very recently when defensive sectors have taken the upper hand.

Ratio of high beta to low volatility stocks

What happens next? The range-bound (correction through time) and rotational (stealth correction) trading are pitched battles between bulls and bears. One side eventually exhausts its resolve and the market moves to a new level – up or down. Or an event, or significant piece of new information, shifts investor sentiment.”

With the seasonally weakest period for stocks ahead in August-September, and the market already showing signs of a more defensive preference, we will see if investors will revisit the pressure on markets shown this past Monday. If the bears do not break the uptrend, stocks could find escape velocity from all of this sideways trading and charge higher into year-end.

 Market Update

Stocks stumbled badly to start the week with the S&P 500 sliding -1.6%. Fears of economic slowing due to the Delta variant of the coronavirus appeared to upend investor sentiment. But it proved a one-day wonder with investors diving into stocks heavily Tuesday to recover Monday’s slide. The recovery continued Wednesday with another +0.8% added to the S&P 500. Bond yields recovered from their tumble below 1.20% yield on the 10-year Treasury bond. But they fell shy of breaching the 1.30% yield level that has been a point of concern the past week. A relatively stable session for traders Thursday left stocks +0.2% higher. Stocks pushed upward again Friday with a further +1% lift. Earnings from social media companies were big winners in Friday’s trade after SNAP and TWTR posted strong earnings, while credit card companies continued to rise on solid consumer spending.

Stocks shrugged off Monday’s slide to post another positive week. The S&P 500 (SPY) rose +1.98% while the Nasdaq 100 (QQQ) lifted +2.93%. Smallcap stocks (IWM) gained +2.12% for the week.

Warm wishes and until next week.