The Stock Market Correction Playbook

What's a Correction? • Long-Term Trend • 3-Step Checklist

The first three months of the year were great for stocks. The S&P 500 had a smooth ride and was up around 10%. As soon as the calendar turned the page to April, however, there was some turbulence. The market now appears to be in the third week of a correction.

What’s a Correction?

A stock market correction is a term used to describe a relatively short-term decline in stock prices during a long-term uptrend, typically measured by a decrease of 5% - 10% from recent highs. Corrections are normal and historically occur 3 - 5 times per year. Whether they are normal or not, however, they can be unsettling. So here’s a playbook you can use to help navigate through market corrections.

The Long-Term Trend

Whenever the stock market begins to decline, it’s helpful to zoom out and focus on the long-term trend. The chart above is the S&P 500 Index over the last three years. On the chart, there’s an orange line. That line is the 40-week moving average trendline - my North Star. If we’re above that line, we’re in a long-term uptrend. If we’re below it, we’re in a downtrend - simple and effective.

Right now, the long-term trend is up, and after a nearly vertical ascent from November through March, a correction like we’re experiencing now isn’t surprising as investors take some profits.

The 3-Step Checklist

After defining if we’re in a long-term uptrend or downtrend, we can move on to shorter-term time frames and take it day-by-day with a 3-step process.

Step 1 - The market needs to get back above its 21-day moving average. Just as I use the 40-week moving average above to define the long-term trend, I use the 21-day moving average (approximately one month of trading days) to define the short-term trend. We want to see prices recover enough that they get back above this short-term trendline. I’ll use the stock market correction from last August through October as an example.

The market first fell below the 21-day line in early August at the start of a three-month correction. About a month later, it recovered and got back above the trendline but then fell back below it in September. The same thing happened again in October before the market finally bottomed. This shows us that the 21-day moving average is useful but can have false signals, called whipsaws, and it is not sufficient on its own, which brings us to Step 2.

Step 2 - The market needs to break out above its most recent high. Just because the stock market stops going down and begins a short-term uptrend doesn’t mean it’s back in stride with its longer-term uptrend. To help confirm that the long-term trend has resumed and the correction is over, we want to see the market break out above its most recent high, which typically signals the start of a new short-term uptrend.

Using the same example from Step 1, during last fall’s correction it took the market three attempts to clear its most recent high. But when it finally did in early November, it was off to the races for stocks. So what made attempt #3 different from #1 and #2? Momentum!

Step 3 - Momentum needs to hit 60. Momentum is the most powerful thing in sports, life, and investing. Fortunately, we can quantify it in the stock market using a tool called the relative strength index (RSI). In a correction, when the RSI falls below 40, prices usually begin to form a bottom, and we get a bounce from investors buying the dip. We want to see some power after that initial bounce with a momentum reading above 60.

It was that strong momentum last November when the RSI powered through the bright green hurdle of 60 that made the third attempt a successful one. That’s what we’ll be looking for in the coming days, weeks, or months. I’ll be sure to keep you posted.

Until then - trust the long-term trend,

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