Crashes, Corrections, and Bears – Oh My!: Quarterly Market View – Q1 2018

“Far more money has been lost by investors preparing for corrections, or trying to
anticipate corrections, than has been lost  in corrections themselves.” – Peter Lynch

 

Volatility comes in waves.
What matters most is how investors ride them.

Volatility is back. And with it, a greater frequency of questions. Like—What is a correction? What is a bear market? What is a crash? What really matters? Most importantly, Am I going to be OK? Before discussing the current environment and the latter two concerns, we’ll start with some definitions and a brief historical background.

• A correction is the term used to describe a 10% drop in the price of the overall stock market over a short period of time.

• The definition of a bear market can vary, but a drop of 20% combined with widespread pessimism would be considered one; bear market conditions typically last longer than a correction. If we were to use a 20% decline over a two-month period as a definition of a bear market, there have been 32 bear markets since 1900, averaging one every 3.5 years.

• While a crash has no technical definition, the term is usually reserved for dramatic declines over a short period of time. Both corrections and crashes can evolve into bear markets, but even using the term loosely, crashes are few and far between.

The Crash of 1929 saw a 23% decline in prices over a two-day period and eventually saw the value of the U.S. stock market lose 89% of its value. Black Monday in October 1987 saw the Dow Jones Industrials (the Dow) drop more than 22% in one day; many people blame the then-common practice of portfolio insurance used in some of the largest pension plans, but that’s an interesting story for another day. The onset of the Global Financial Crisis (GFC) generated its own crash in late 2008, in which the market dropped 21% in a week and continued into a bear market, which culminated in a 50+% peak-to-trough decline.

ENTER 2018

February’s headlines wrung all the drama they could out of market events. Here’s an example:

Buyers charged back in and limited the damage, but at the closing bell the
Dow was still down 1,175 points, by far its worst closing point decline on record.

We’re not going to get into the issues with using the Dow as a proxy for the U.S. stock market—except for two nuances that could earn you some street-cred at a cocktail party. First, the Dow only covers 30 of the roughly 4,000 listed U.S. companies. And second, it’s a price-weighted index, which means a company like Boeing with a share price of $350 has more than a 20x impact on its point movement than a company like GE with a share price of about $15. The point here is that the price of an individual share, since companies have different numbers of shares outstanding, is irrelevant.

The crux of the issue is that “Dow Plunges During its Worst Point Drop Ever” sells far more clicks (and newspapers still, we suppose) than “Dow Down 4.6%.” The key word here is points. The Dow only dropped 507 points on Black Monday October 19, 1987, but that equated to a drop of 22.6%. If they can’t sensationalize it with percentages—which is what matters—then they’ll sensationalize it with points—which don’t.

RECOGNIZE CLICK-BAIT

The fact is, what we saw in February was the Dow’s 100th-worst fall in history, in percentages—hardly something worth losing sleep over. February’s volatility, as a matter of fact, was somewhat of a return to normalcy.

On December 19th, 2017 we saw the headline “Stock-market volatility isn’t going to come roaring back” based on a note Morgan Stanley wrote to its clients. And on January 2nd (in the same news source), we saw “Stock-market volatility could return in a big way in January” based on information provided by Goldman Sachs.

What’s really going on? Headlines feed people’s confirmation bias. People tend to seek (and click on) information that confirms their own beliefs. If people are already fearful about investing, they’ll tend to read articles that reinforce their own fears. If they’re not, they’ll click on things that confirm the opposite. “There is going to be some volatility, but nothing bad is going to happen and stocks are going to finish 2018 up a little” isn’t going to make it above the (increasingly antiquated) fold.

Always remember: News agencies need clicks to pay their bills, and when there is little news, that’s bad news for a 24-hour media cycle. Since an erroneous article online can be quickly and easily taken offline with almost no artifact of its existence, there is just about zero accountability anymore. We’re not claiming that we’ve been overrun with fake news, but we may be approaching yellow journalism. The digital version of this is called click-bait. And those whose paychecks depend on people clicking on their headlines have become very good at eliciting that behavior.

2017 WAS UNIQUE IN SEVERAL WAYS

2017 was the quietest year for stocks since JFK was President as measured by nearly every metric. If we use absolute daily percentage change, it was the lowest in 52 years. Despite a plethora of hurricanes making landfall in the U.S., the threat of nuclear war from the North Koreans, and the tweets from an unorthodox administration, nothing was able to extinguish the 2017 bull market.

In 2017, the biggest single-day drop  was less than 2%. We should expect, on average, about six days per year to have a greater-than-2% drop—and 2017 had none. Each year since 1980 an average peak-to-trough drop of nearly 14% occurred at some point during that year; yet, out of those same 38 years, 29 finished positive.

AM I GOING TO BE OK?

The average downturn lasts about 12 months and takes about 24 months to recover. As long as you don’t need to withdraw funds from your portfolio, corrections may have certain benefits. Rebalancing may provide additional returns through volatility pumping, which is a fancy way of saying that by buying more shares when prices are down, a portfolio can recover not only more quickly, but to a greater value if done correctly.

Corrections also allow for tax loss harvesting. If a $1mil portfolio goes down 10%, the losses can be harvested. When it recovers back to a $1mil value, the investor has captured a $100k capital loss. This can be used later to offset $100k worth of capital gains taxes. Your net return might be zero, but you’ve now got the ability to offset potentially tens of thousands of dollars in taxes in the future depending on your tax situation.

Lastly, even though we said as long as you don’t need to withdraw funds from the portfolio, that may not even be of concern either. Provided that the portfolio is effectively diversified, needed funds could be pulled from an asset class that isn’t currently depressed.

WHAT REALLY MATTERS?

You’ve likely heard the horror stories of investors since 1999 who bailed after losing a significant amount of the value of their portfolios—twice. First, they jumped out of the markets after the dot-com meltdown. They ultimately reentered the market at a premium, then panicked and sold everything again in early 2009, only to repeat the same mistake.

What happened here? If investors didn’t need all their liquidity in 2002, why would they sell everything? Sure, tech companies were overvalued, but in the meantime, everything else was paying a dividend, and bonds were paying well. Heck, 10-year Treasuries were earning 4-5% per year.

And yes, 2009 was abrupt. Yet, while Jim Cramer wasn’t helping anything, if you didn’t own too many condos in Florida, the real carnage was over relatively quickly. This can be a behavioral coaching moment: Time slows down during a crisis, but a disciplined investor would have taken advantage of the buying opportunity and rebalanced into it, ending up with considerably more shares than previously.

This is not an easy thing to do. The fact is, people’s risk tolerance is non-stationary: It changes, and we get that. There will be times when our clients need coaching and support, and we’re here to provide it.

Volatility will come back, but if you ride it correctly by taking advantage of tactical shifts like the Moving Daily Average, using tax loss harvesting strategies, and rebalancing among low-correlated assets, it can provide additional opportunities that simply “riding it out” doesn’t offer.

We’ll close with two sublime perspectives:

“Success is not final, failure is not fatal: it is the courage to continue that counts.” – Winston Churchill

“You can’t stop the waves, but you can learn to surf.” – Jon Kabat-Zinn


RISKS AND DISCLOSURES

The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice.

All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.

This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.

It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.

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