The Word “Correction” Misleads Us About What Small Stock Price Drops May Signify


I have seen several articles lately talking about stock market corrections and what they signify. I don’t like the word. I think it serves more to cause confusion than it does to aid understanding.

10 percent price drop
StockSnap / Pixabay

A “correction” is generally defined as a 10 percent price drop. Stocks are today priced  at two times fair value. So how are prices “correcting” if they drop by only 10 percent? The suggestion of course is that a 10 percent price drop would bring prices closer to fair value than where they were previously. But the further suggestion is that prices will be primed to begin moving upward again following the correction. I don’t believe that we can ever know where prices are headed in the short term. So I don’t believe that’s so. And when stocks are still priced at levels far beyond their fair value, the long-term price direction is almost certainly downward. So any suggestion that a correction taking place from these price levels should reassure investors that stocks are safe to own again is unfortunate.

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The idea that stock prices occasionally need to correct suggests that there is a proper amount by which prices should increase and that price drops are needed when a long-term upward price movement gets ahead of itself. I question whether a long-term upward price movement should be accepted as the norm at a time when prices are already at two times fair value. At these prices, a long-term downward movement in prices should be expected. So a short-term downward movement should be viewed not as a short-lived correction but perhaps as the establishment of a new price direction.

The term “correction” is on the surface sending a negative signal. The idea is that prices are headed downward and that that’s a bad thing. But the message being conveyed is as much positive as it is negative. To say that the market is “correcting” is to offer reassurance that the downward price movement will be exhausted quickly. The negative message is swallowed by the positive one in which it is wrapped. The message is so mixed that it is hard to make sense of it.

To say that the market is “correcting” hints that the market is remaining in control of itself. It’s not that the market is panicking or retreating. It is taking a little breather. It is of course possible that the market really is taking a little breather. I don’t think that we can know the short-term direction of market prices. But I am reluctant to ascribe too much rationality to a market priced at two times fair value. A market priced at two times fair value is a highly irrational market. It might be taking a little breather. But it is possible that the breather will be followed by a sharper downward movement rather than by a reversal in direction.

What’s really going on is that investors are pushing stock prices in a downward direction to test their own reactions to a new state of play. If someone is unhappy in a relationship, he or she might pull back from it a bit to see if the pullback causes changes that make the relationship more satisfying. You might say that the relationship went through a correction. But the pullback might not bring on positive changes. So the small pullback might become a bigger pullback and then a complete break. So it could be with a correction in stock prices. Investors might send prices downward only a bit to see if that helps them regain confidence in their investment. The test might restore confidence or it might not do so. A test that does not restore confidence could well cause confidence to plunge.

Not all 10 percent price drops are corrections. That’s the point. In some cases, a 10 percent price drop will quickly reverse and the old prices will be restored. In other cases, a 10 percent price drop will create a new price level that will remain in place for some time. And in yet other cases a 10 percent price drop will be followed by another 10 percent price drop and then perhaps another 10 percent price drop. So why conclude before the 10 percent price drop is concluded which way things are going to go? Why assign the name “correction” to a price movement before the reality reveals itself? Calling a price drop a correction is a way of jumping to a conclusion before the evidence needed to arrive at an informed conclusion is available.

I certainly don’t mean to say that the price drops of recent days are signalling much bigger price drops in the days ahead. I am saying that I don’t know whether they do or not. And I don’t believe that those who have labeled the price drops a “correction” know either. The one thing that I believe we can know is that the risk of a much bigger price drop is much bigger than it would be if prices were at more reasonable levels. The more prices rise above fair-value levels, the greater the risk there is of a big drop. But we don’t know when the big drop will come. So we should try not to overreact to small price drops.

We should try not to underreact to them as well. To call a small price drop a correction is to rule out scary possibilities before it is possible to rule them out with confidence. It is an emotional trick we play on ourselves. We call small price drops corrections to assure ourselves that they will not turn into big price drops. But it doesn’t always work. There is a part of us that finds appeal in the idea of permitting a larger price crash because it is only when we see more reasonable price levels that we will be able to feel true confidence in the future prospects of our investment money.

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