Investing basics: What is a market correction, and what happens next?

After recovering from the sell-off in 2020, the stock market has been on the rise for much of the past two years. That changed at the beginning of 2022 as the US market started to slip from its record close on Janruary 3. On February 22, the S&P 500 closed in a correction, down 10% from its recent high. Investor anxiety about the end of economic stimulus and the war in Ukraine may have contributed to the decline.

As the S&P 500 continues to waver, you might hear the terms “market correction” and “bear market” in the news to discuss the stock market. We define the terms and look to historical events to give context to what’s happening now.

What is a market correction?

A “correction” refers to a stock market decline greater than 10% but less than 20%, usually measured by the S&P 500 in the United States. The 10% threshold is arbitrary, but it represents a significant decline. A correction can last any length of time, from days to months or more. Market corrections are fairly common (including this year, there have been 11 of them since the year 2000) and usually short-lived. Historically, market corrections have lasted an average of three to four months.

While market corrections can hurt short-term investors, they present potential buying opportunities for those with longer investing horizons. The term “correction” comes from the historical tendency for these price drops to “correct” the market by returning prices to their longer-term trend.

Declines of 20% or more enter bear-market territory.

What is a bear market?

Bear markets are usually defined as stock market declines of at least 20%. They can last any length of time, though they tend to last longer than market corrections. Wall Street considers bear markets over when the stock market closes at a new record high.

The start and end of a bear market, however, can only be determined after the fact.

Although a bear market is declared once the stock market falls at least 20% from its previous high, the entire decline is considered part of the bear market. Similarly, the following market rally, or bull market, is declared once the market reaches a new all-time high, but it includes the entire recovery from the low point of the bear market. The chart below shows 2020’s stock market decline and subsequent recovery to illustrate the timeline of a bear market.

The bear market in 2020 was the shortest ever, lasting only a month. Previously, bear markets have lasted an average of about nine and a half months. Still, these periods of decline have been shorter than periods of growth.

What causes market downturns?

Movements in the market have to do with investor sentiment--if investors are more inclined to sell than buy, prices will drop. Compared with a market correction, a bear market indicates a greater crisis of investor confidence about the future. The causes of investor pessimism can vary. The most common trigger is a weak or slowing economy or the anticipation of an economic slowdown. Alternatively, investors may feel that the market is too hot and prices too high.

Signs of an economic slowdown or other events may cause investors to become pessimistic about the prospect of future returns on investment, prompting them to sell shares. The market declines as a sell-off gains momentum and pessimism spreads.

Although bear markets often go hand in hand with economic recessions, they are associated with different issues. A recession describes a slowdown in economic output and is generally defined as at least two consecutive quarters of decline in gross domestic product, or GDP, which functions as a measure of economic health.

In short, the stock market is not the economy; the market may be up even as economic output is down.

Do all market corrections lead to bear markets?

The answer is no. In fact, most market corrections have not led to bear markets. Going back to 1975, only five of the 24 market corrections have turned into bear markets. But as difficult as it is to predict the duration of a market downturn, there is also no surefire way to predict whether a market correction is actually the start of a bear market.

When and why does trading stop?

While it may take days or weeks to enter correction or bear-market territory, sudden stock market declines can happen during a single day of trading. Extreme, broad declines in the market during a trading day trigger marketwide circuit breakers, automatic mechanisms that put a temporary stop to trading.

These circuit breakers were triggered multiple times in March 2020 in response to concerns over the impact of the spread of coronavirus in the United States.

The idea behind an automatic halt to trading is to calm panic-stricken markets. The circuit breakers force investors to take a brief pause from the ongoing chaos, review and reassess the situation, and acquire and assimilate information. According to the New York Stock Exchange, the purpose of the circuit breakers is “to slow the effects of extreme price movement through coordinated trading halts across securities markets when severe price declines reach levels that may exhaust market liquidity.”

In an era of high-frequency computerized trading, circuit breakers are intended to act as a speed bump when markets are in a tailspin and help restore calm. The overall effectiveness of these measures, however, is debatable.

How do circuit breakers work?

There are three thresholds that activate the automatic stock market trading halts amid sharp, substantial downturns and volatility, as measured by the S&P 500 for US markets:

• A Level 1 circuit breaker triggers a 15-minute trading pause when the market falls 7% below the prior day’s close.
• A Level 2 trading halt kicks in when the market slides 13%. This pause also lasts 15 minutes.
• A Level 3 circuit breaker is activated when the market drops 20%, suspending trading for the remainder of the day.

Level 1 and 2 halts are triggered only if the market drop occurs before 3:25 p.m.; trading will continue if the fall occurs at or after 3:25 p.m. A Level 3 halt can kick in any time during the trading day.