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Why the Nasdaq in correction territory may be a short-term buy signal

The Nasdaq Composite (^IXIC) finally slipped into correction territory Wednesday for the first time since March 2021 — prompting bearish headlines and warnings from pundits. But a Yahoo Finance analysis of nearly 50 years of Nasdaq data reveals this may be a short-term buying opportunity.

A market correction is traditionally identified as a drop of 10% or more from a recent high, measured from the closing high to the closing low. The threshold is admittedly arbitrary, but nevertheless it generates headlines and draws investor attention. 

Going back to 1973, there have been 27 times when the Nasdaq fell into correction. Through 1996, the following day’s returns tended to be negative. But since 1997, the day after has been positive 13 out of 14 times, for an average return of 1.78% and a median return of 2.09% (which, incidentally was the high intraday return on Thursday as of noon ET). Looking ahead to the 5-day return, it has averaged 2.83% since 1997 with a median return of 2.97%.

Returns after Nasdaq Drops into

There’s a 15-year gap in the above table from roughly 2000 to 2015 because the Nasdaq was not making record highs during this time — having been beaten down by the tech bubble crash. Substituting the 52-week high — or the highest price in a year — produces a larger sample size. 

From 1997, there are 22 Nasdaq corrections from 52-week highs, of which 16 produced positive returns the next day, with the next five days positive 19 out of 22 times. The average and median gains are lower for this group, but still compelling with a 2.54% average return and 2.70% median return after five days.

While the price behavior could be simply random, many short-term traders like to fade — or take the opposite position — from a prominent bullish or bearish indicator. That’s because short-term sentiment may have become extreme in one direction or the other. 

Returns after Nasdaq Drops into

Similarly, when the 50-day moving average crosses below the 200-day moving average, it generates a so-called death cross. While this is long-term bearish, the market will often consolidate or bounce in the short term after the signal is generated. Traders also like to fade, or take a position contrary to, high-profile magazine covers, such as the August 1979 cover of Business Week that famously declared the “Death of Equities.” Buying the S&P 500 back then set up a 200% rally into 1987.

To be sure, markets face a number of headwinds this year that are likely to frustrate both retail and institutional investors alike — surging inflation, a hawkish Federal Reserve, geopolitical tensions, plus COVID. 

As the Nasdaq was set to issue its bearish technical warning Wednesday, Heritage Capital President Paul Schatz gave his market outlook for 2022 on Yahoo Finance Live. “[M]y roadmap would be something like a pullback in the first quarter. We regain it in the second quarter,” he said. “The bigger decline comes in the third quarter. We regain it in the fourth quarter. The year is all about patience, frustration, and quality. So that could be a fun year.”

UPDATE Jan. 20, 2022 6:09 p.m. ET: Thursday’s post-correction signal return in the Nasdaq was -1.30%, lowering the reliability of the signal to 13 out of 15 times since 1977. The 5-day return will be known as of the close on Jan. 26, 2022.

Jared Blikre is an anchor and reporter focused on the markets on Yahoo Finance Live. Follow him @SPYJared.

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