We are in the midst of the 28th time the stock market fell between 10% to 20% since 1945. A peak to trough move in prices such as this happens every three years on average. It should be expected by stock investors. The speed of this fall, however, was extremely quick. It spanned only two weeks in time. On average, these declines average 14%. Typically, the fall lasts four months and takes another four months to recover.
Declines in the S&P 500 (Since 1945)
Source: Ned Davis Research, Guggenheim
As it stands today, we do not know if this will be a fall greater than 20%, which has happened 11 times (8 between 20% to 40%, 3 greater than 40%). Typically, recessions cause declines greater than 20%. Absent an external shock like a trade war, a recession seems unlikely this year. Fundamentally, the economy looks strong. Wages for individuals and earnings for companies are higher. Still, it is the ninth year of this economic expansion and the Federal Reserve is hiking interest rates. We are most likely in the later innings of this cycle.
Why has the market crashed? It is always tough to pin down the exact reason for more sellers than buyers. Here is our best stab at it.
- Blow up of the “short volatility” trade. Every so often a strategy perks up that is akin to picking up pennies in front of a steam roller. It works great until it doesn’t, and all of the profits that were made the last few years vanish. People were betting on the volatility (or variation in the price) of the stock market to keep falling. When volatility instead increased at an exponential higher rate (more than quadrupling in just two days!), that trade gave back all its gains and then some, falling 80% to 95%.
- Inflation expectations rising. With the new tax plan, federal budget passed, and an infrastructure plan looking possible, interest rates began to rise to price in the higher risk of inflation. Economists have been dumbfounded as to why there is no inflation. To us, its been clear the private sector has been starved for fiscal stimulus. With a one-two punch of lower taxes and federal spending, this puts more money in motion and in the private sector’s pockets. In turn, this increases inflation expectations, which tends to lower profit margins for companies and the stock market as a whole.
- Too many people being too positive on stocks. Disagreement is what makes a market. When everyone agrees that stocks should go higher, as they did in the consumer confidence survey last month, everyone is all in. Without fresh buyers, no one was left out of the boat. Equity holdings for households were the highest ever since the technology bubble in 1999.
A washout of bad strategies and investor sentiment is ultimately good for long term investors. In the moment, the feeling can be terrifying. While the past is a guide, we remind ourselves that the unexpected happens. Markets are not a “normal” distribution and outcomes different and in greater magnitude than the past are possible.
Systematically executing is a way we combat behavioral biases. Human emotions are not built for a world where we see our (monetary) resources on screens, instantaneously going up and down in bright red numbers. It creates an urge to protect resources and often stop the pain, by reacting emotionally. Our rational mind should re-frame falling prices as an opportunity for higher expected returns.
The best approach is not to predict the short-term gyrations. Have your shopping list handy and stick to your investment plan. Our Investment Committee regularly updates the prices of all asset classes where we would be buyers in the event of a decline or crash scenario. This way, there is no question in the moment of what to do.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.