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Context Is King: What Previous Downturns, Turning Points Tell Investors

Charles Paikert, New York, September 22, 2020

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Past market falls and shifts can help inform investors about the current environment, but one vital take-home point is that patient investors tend to be rewarded. Today's stock market, with its wide dispersion of returns, also puts the case for active management under the spotlight.

How can previous market downturns and turning points help investors put the pandemic-induced freefall of the US stock market last spring into context?

Simply put, the lesson is to have patience: markets always recover, say Morningstar Canada’s director of research Paul Kaplan and Laurence Siegel, director of research for the CFA Institute Foundation. Both men spoke last week at Morningstar’s virtual Investment Conference.

Kaplan identified 14 bear markets when US stocks have dropped by 20 per cent or more since 1870. His key finding was that: “the market always eventually rebounded and went on to new highs.”

To be sure, the duration of the bear markets varied widely and caused pain in the interim period. The worst US market decline was the famous Wall Street Crash of 1929, when the market dropped by 79 per cent and took eight years to recover. After the dot-com bubble burst in August 2000, stocks declined by 54 per cent through February 2009, a period known as “The Lost Decade.”

Although the market began recovering, it slipped back again after the crash of 2007 to 2009 and didn’t regain its full value until May 2013. After that, however, The Dow Jones Industrial Average went on to shatter old records and reach an all-time high this past February.

Siegel noted that because the news media highlights bad news, investors tend to become frightened when markets fall and many bail out. What they don’t hear - because the media barely reports what he calls “the slow steady drumbeat of progress in between disasters” - is encouraging news that signals optimism for the future.

As a result, the stock market “is the only establishment where when there’s a sale and prices are low everybody runs out of the store when they should be buying.”

Bear markets - Black swans or black turkeys? 
Investors need to remember that bear markets are relatively frequent occurrences, Kaplan said. In fact, he pointed out that bear markets occur roughly every nine years. Historical stock market return data “provides clear evidence that market crashes aren’t as unique as one might have thought,” he stated. 

Nevertheless, the media tends to portray market crashes as “black swan” events, a rare occurrence that comes out of the blue that no one could have predicted. But Siegel says a better term is “black turkey,” which he defines as an unwelcome event which is “is everywhere in the data - it happens all the time - but to which one is willfully blind.”

COVID-19, a novel virus unleashing a plague that the world hadn’t seen in over 100 years, certainly wasn’t predictable. But Kaplan and Siegel point out that the subsequent market crash and recovery underscores the lesson investors could have learned from previous price collapses to hang tight and not panic.

The coronavirus crash in March was unique because it wasn’t caused by underlying economic problems, Siegel noted, but by an unprecedented lockdown of businesses by governments. The Dow and the S&P 500 responded by plunging by about 35 per cent within six weeks this spring, the most rapid decline in history.

COVID market volatility: ‘No analog in history’
But investors with fortitude and patience were rewarded in an equally unprecedented fashion. By mid-September, the Dow and the S&P 500 neared their all-time highs. Despite a background of the continuing pandemic, a recession and high unemployment, the recovery took just 126 trading days, the fastest-ever ascent for beaten-down equities.

“I don’t think there’s any analog in history that looks like this,” Benjamin Bowler, head of equity derivatives research at Bank of America Corp. told the Wall Street Journal.

The rapid recovery was a stark reminder that investors who sell off during a market crash usually “don’t act in their own self-interest,” Kaplan said. “They don’t realize that the nature of the beast is the market also has an upside [following a downturn].”

But Kaplan and Siegel also warned that the market’s strong performance in the face of grim economic headwinds is “puzzling” and shouldn’t lead to investor complacency.

Two-tiered market
Most of the year’s market gains have come from tech giants Apple, Amazon, Microsoft, Google parent Alphabet and Facebook, which together make up nearly a quarter of the S&P 500, Siegel pointed out. Indeed, Apple’s stock gains alone have accounted for more than half of the index’s nearly 5 per cent total return this year.

“It’s a two-tiered market,” Siegel said. “Most stocks have not recovered.”

The stock market, in fact, comprises the country’s largest and strongest companies and is not representative of the entire economy, William Ackman, principal of Pershing Square Capital Management wrote in a recent letter to shareholders. “If there were a stock market of private, small businesses,” Ackman maintained, “it would likely be down 50 per cent or more.” 

Investors can thank Congress’ stimulus spending in the spring and the Federal Reserve Board’s commitment to boosting markets through ultra-low interest rates and buying huge quantities of mortgage-backed and Treasury securities for preventing the economy from tanking.

Despite persistently high unemployment, weak wage growth and the decimation of entire industries such as retail, travel and entertainment, equity markets appear determined to “climb the wall of worry,” Siegel said.

Post-pandemic optimism
Once pandemic restrictions are lifted, investors are convinced that the US “will go back into a period of normal economic growth and earnings will boom again.”

Everything about the COVID-19 crisis “has been outsized and has moved at warp speed,” said Jim Paulsen, chief investment strategist at The Leuthold Group, a Minneapolis-based investment research firm, wrote the firm’s clients last month.

“If the economy continues its economic recovery and real GDP growth is anywhere close to the current consensus view, the stock-market bull may just be getting warmed up,” Paulsen said.

That’s good news for patient investors who recognize that market risk “includes the possibility of depressed markets and extreme events,” as Kaplan put it.

“While those events can be frightening in the short term,” he concluded, “for investors who can stay in the market for the long run, equity markets still continue to provide rewards for taking those risks.”




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