There’s nothing magical about a 10% drop in a stock index that Wall Street considers a correction. So we have to stop taking this 10% mark as meaningful. It is not.
The probability of a stock rising after a 10% drop is no different than it was before. Now it’s important to note that the Nasdaq Composite Index Comp,
is rapidly losing ground, down 2.5% on January 13 alone and 7.8% from its high on November 19, 2021.
To show that this 10% correction range is of no importance, I analyzed all opportunities since 1928 in which the S&P 500 SPX,
(or its preceding index) dropped at least 10% from the previous high. In some of these cases, the market continued to decline and entered bear-market territory by falling at least 20% below the market high. In other cases, the market reversed almost immediately and rose again.
To calculate the overall odds of the market on all such occasions, I focused on the exact days on which the S&P 500 breached the 10% range for the first time. Back in those days, there was no way to know whether the market’s downturn was almost over or something worse had begun. The chart above reports the average gains of the S&P 500 over the weeks and months following these particular days.
None of the differences depicted in this chart are significant at the 95% confidence level that statisticians often use when determining whether a pattern is real. In any case, note that the average return of the stock market is often higher in the days following which the stock market first steps into the sand at the 10% drop line.
It could be that these results are being skewed by some outsiders. To test that possibility, I calculated the odds of the market in a different way: the percentage of the market was higher in the subsequent months—quarters—at six months and 12 months. The chart below reports the odds calculated in this second way. Again, any difference is not statistically significant.
What is the interpretation of these results?
You might be surprised by the data on these charts, but you shouldn’t. The stock market is looking ahead. The market level at any given time already reflects all the known information. This includes how the market has performed up to that point.
For example, let’s imagine that breaking the 10% downside threshold would actually indicate that market prospects had suddenly turned bad. In that case, investors would immediately sell the stock upon such a breach, pushing prices down even further until the market reached equilibrium. This is how market efficiency works. The net effect would be that the threshold ceased to be meaningful.
The next time the market breaks this 10% threshold, what does it mean? If you’re looking backwards, you might be mourning a 10% drop. But as an investor, looking ahead is what you want to do.
Mark Hulbert is a regular contributor to Businesshala. Their Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. he can be reached here [email protected]
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