Can We Predict a Market Correction?

A correction in the equity market refers to a downward movement in stock prices after a sustained period of growth. Market corrections can be triggered by various factors such as economic indicators, changes in investor sentiment, or geopolitical events. During a correction, stock prices may decline by a certain percentage from their recent peak, signaling a temporary pause or reversal in the upward trend.

Reference [1] examines whether a correction in the equity market can be predicted. It defines a correction as a 4% decrease in the SP500 index. It utilizes logistic regression to examine the predictability of several technical and macroeconomic indicators. The author pointed out,

The study employed a logistic regression model to forecast the likelihood of negative market movement at time t+1, with publicly available information at time t. An extensive literature review guided the selection of a composite of macroeconomic, financial, and option metric indicators to serve as predictive variables for the regression model. Among the eight chosen predictors, Volatility Smirk, Open Interest Difference, and Bond-Stock Earnings Yield Differential (BSEYD) emerged as statistically significant predictors of stock market corrections, with their statistical significance being notable at the 1% level, and thus also satisfying the higher t-statistic requirement introduced by Harvey et al. (2016).

In short, the following indicators are good predictors of a market correction,

• Volatility Smirk (i.e. skew),

• Open Interest Difference, and

• Bond-Stock Earnings Yield Differential (BSEYD)

The following indicators are not good predictors,

• The TED Spread,

• Bid-Offer Spread,

• Term Spread,

• Baltic Dry Index, and

• S&P GSCI Commodity Index

This is an important research subject, as it allows investors to manage risks effectively and take advantage of market corrections.

Let us know what you think in the comments below.

References

[1] Elias Keskinen, Predicting a Stock Market Correction, Evidence from the S&P 500 Index, University of VAASA