The definition of a stock market correction is when stocks decline more than 10%from a recent high. A crash however is when the stock market falls 10% in one day. We recently saw the Dow Jones drop 831.86 points on 10 Oct 2018. This was a 3.1% drop and the biggest sell-off of the year to date. However, this would only be considered a correction and not a crash. These are the reasons a stock market may correct.
What causes a stock market correction?
Stocks are over priced
A stock can be considered overpriced when the price per earnings ratio is high. This means investors believe the company will grow in the future and are willing to pay a premium in comparison to the earnings the company is generating. When the overall stock market is down, growth stocks will be the first to be decline. The irrational exuberance that investors feel when the stock market is up is now no longer there when the stock market is falling. Hence these speculative investors may start selling their high PE stocks, in turn causing large falls in these growth stocks. If stocks keep increasing in price but their fundamental value does not rise then they can be seen as overvalued and an asset bubble can form. In times of correction, investors are contemplating whether these stocks should be a such levels.
Panic in the market
The stock market is driven by investors who are driven by emotion. Just like investors can have irrational exuberance when the market is climbing, the same psychology can be applied with the market is falling. Investors seeing the market falling such large depths will panic and feel their stocks will lose too much value and start selling off. Hence corrections may occur as the emotion of panic becomes contagious with investors.
The number of sellers outweigh the number of buyers
The prices of a stock are determined by demand and supply. If there is high demand for a stock than investors will willing to over pay for a stock and if a stock is low in demand, then sellers will be willing to sell the stock at a very low price to eliminate the position. When the stock market has a sell off or a correction, there is a lack of buyers in the market and an abundance of sellers in the markets. Sellers start lowering their stock prices until it matches a buyer’s price. As there are not a lot of buyers, buyers will wait until they receive the offer they want. This activity can cause stock prices to drop more significantly as investors may be desperate to sell and lower their price aggressively.
Concerns about the economy – bond yields going up
The stock market has recently been falling hard due to increase fears of a rate hike from the US Federal Reserve. The US economy is expanding and the Fed, in order to control inflation, has been raising rates. High interest rates are a negative for the stock market as it means higher borrowing cost and lower company valuations. We have written about this recently – The Effect of Interest Rates on the Stock Market. When interest rates rise, stock prices decrease. The borrowing capacity of companies is restricted when interest rates are hiked which can impede expansion of the businesses and this ultimately affects company’s earnings and stock prices. Economist are now predicting a slowdown of the US economy next year after reaching a peak. If interest rates continue to be raised this could worsen this slowdown of the US economy.
The market is also concerned with how the economy is going to impacted with the trade wars. The state of the economy is one of the factors investors evaluate. The International Monetary Fund has now forecasted global growth to fall with Trump’s trade war with China and Europe. This has been concerning to equity investors and has prompted the sell off in the markets recently.
As always though, while investors are fearful of these things happening, it doesn’t mean that they actually will. This means that in some instances, stock market corrections may represent opportunities to buy good companies at cheaper prices.
Lauren Hua is a private client adviser at Fairmont Equities.
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