The Nasdaq quickly falls back into a correction

Key points:

• The Nasdaq Composite suffered a correction, partially recovered, and then fell right back
• The Nasdaq 100 index of larger tech stocks suffered the same fate
• While assumed to be a sign of smart money distribution, multiple successive corrections actually preceded average returns

Successive corrections

Near the end of August, stocks were amidst a torrid recovery, and investors started to assume that fresh all-time highs were around the corner.

Not so fast. Just as quickly as the gains materialized, they disappeared. Or much of them, anyway. The Nasdaq Composite made a roundtrip from correction territory to well within a pullback, back beyond a correction.

Due in part to the prevalence of post-nominal honorifics among technicians, it has become widely believed that this behavior is typical of market peaks. Multiple successive corrections are believed to represent smart money institutions offloading inventory to late-coming retail traders, culminating in a protracted decline as the latecomers realize their mistake and sell in a panic to the very institutions that sold to them in the first place.

That's the theory, and it's enticing.

In practice, it's not so clear. In fact, it's pretty much wrong. It has preceded some significant peaks - well, one - but mostly, it led to recoveries. The table below shows every time the Nasdaq Composite was at least 10% from a multi-year peak (for convenience, we'll call this a correction). Then it recovered to within 4% of that peak and quickly fell back to more than 10% below. 

The first three times this occurred, the Composite lost at least another 10% over the next month before staging recoveries. Since then, it has rarely led to a decline in any time frame. Over the next year, the index sported double-digit gains every time.

The NDX has suffered the same thing

The Nasdaq 100 is more concentrated and often more volatile than the Composite. It shows a similar pattern: a -10% correction, recovery to within 4% of its high (rounded), and then a decline back into correction territory.

Because of that increased movement, the Nasdaq 100 has more often suffered repeat corrections. Over the next six months, the NDX showed gains after 11 out of 12 signals. That single loss was a doozy, however, as it coincided with the pricking of the internet bubble.

You might look at the chart above the table and think, "In 2020, that looks like a straight-up move with no corrections." However, when we zoom in, we can see that the pattern was similar, with a 10% correction, partial recovery, and then a quick drop back into a correction. That was about it for the selling pressure.

What the research tells us...

A common refrain in the stock market is that increased volatility at all-time highs is a sign of "smart money" distribution. There is some evidence that this is the case, but it depends on how it's measured.

If we're looking solely at the arbitrary definition of a correction when we see multiple ones in quick succession, it has not been a consistent sign of impending doom; quite the opposite, actually. While the risk/reward ratio of buying the 2nd correction wasn't all that great up to a couple of months later, longer-term returns were more compelling and consistently positive.