There is an old saying that stocks go up in escalators and down in elevators. To better understand how the stock market has responded to elevator rides, the table below shows the worst performing quarters for the S&P 500 from 1940 - 2017.
The last row indicates that the average loss during the worst quarters was just over 20%. While that’s a brutal move in only three months, the subsequent one, three, and five-year returns are staggering. It is as if the index was placed in a slingshot, pulled back, and released.
Given the drivers of each downturn were presumably different, the index’s consistent recovery is even more remarkable. Let’s consider this not-so-hypothetical scenario to better understand why this pattern keeps happening.
Volatility begins to rise for whatever reason and catches the eyes of nervous investors. The media begins to run stories of large one-day losses and how they compare to history. For example, The Dow Jones Industrial Index (DJIA) fell 1,175 points on Monday, February 5th, 20181. At the time, it was the largest point decline in history, which led to the following headlines:
Source: https://www.google.com/search?q=dow+drop on 2/6/2018
Comparing point declines in an index provides zero insight. Only percentage moves matter. The Dow closed the prior trading day at 25,520.96, so a drop of 1,175 points equates to a 4.6% decline1. While that day wasn’t fun, it was not even close to the largest daily percentage loss in history.
But the media does not care. These headlines get people to click on links, and that sells advertising. Market timers and the most skittish investors sell early, which only adds more fuel to the fire. Stories that counter the bears’ narrative get pushed back to page eight (below the obituaries). Economic data and other fundamental drivers are no longer front-page material.
The stock market decline accelerates to the point where it begins to flirt with a “correction” (a decline of 10% from a peak). This gives the media the green light to run stories of a looming recession and invite fearmongers to primetime shows to prophesize the end of the world.
Investors sitting at home begin to panic. What if this is another 2008? Nobody saw that coming, so why is this time any different? After a few weeks of sleep deprivation, the fear and panic become too much. They call their financial advisors and beg them to make the pain go away.
And as they breathe a sigh of relief after those volatile stocks in their portfolio get replaced with the perceived safety of cash, take a guess who is on the other side of that trade with an ear-to-ear grin. This guy.
Professional investors become our most charitable selves in these times. Can’t take the misery of owning stocks that are down over 20% in a matter of weeks? We are here to help. We will gladly take that off your hands, and in the process, convert your short-term pain into long-term misery.
Because the volatility eventually dies down. Panicked sellers exit the market, and stocks stabilize. This prompts the media to quickly shift the narrative, publishing stories of a “recovery” and “buying opportunity” as economic data makes its way back to the front page. Sellers are left to kick themselves for acting so rash, and some may never return to stocks because the scars run too deep.
The Bottom Line
Here’s a pro tip to differentiate between panic and the start of a recession. Stocks are fueled by economic growth over the long run, and the U.S. economy is a massive machine. The fundamentals driving it change slowly and can often be observed.
Think about an oil tanker. Course corrections for a ship longer than a football field take a while to complete, and the trained eye can often see where it is headed by checking its wake, propeller speed, etc.
The U.S. economy is that oil tanker, and when the stock market is moving around like a speedboat, professional investors take notice because something other than fundamentals is usually driving prices.
More often than not, emotions are what decouple the stock market from the economy. But the pros know that emotions almost never derail $22 trillion economies, so they step in, buy up what they can, and then patiently wait for stocks to go back to being fueled by the fundamentals.
The bottom line is that blood in water attracts sharks. The next time fear and panic get the best of you, ask yourself why buyers are so willing to help. What might they know that you don’t, and could that be a sign that cooler heads could prevail?
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.