The Eclipse of Optimism

August 20, 2017

We are coming up on an anniversary of sorts. Two years ago, the stock market had a series of sell offs in the last week of August. China devalued the yuan, commodity prices around the world swooned, and Greece was in imminent default on its loans. Pictures of empty cities in China prompted speculation that the building boom in China was coming to an end and would bring down the global economy. Over the course of 6 days, the SP500 shed 11%.

By year’s end the SP500 was still slightly below its level at the end of August and did not rise above its mid-2015 price till the summer of 2016. Long term assets at the end of 2015 declined slightly for the first time since the financial crisis (ICI 316 page pdf). There wasn’t a rush for the exits but clearly some investors were spooked. Should I get spooked when the next 10% drop comes?

In the past five years there were 73 daily declines of more than 2% in the SP500 index.  That’s more than one in twenty trading days or about one per month.  2% is more than 400 points on the Dow at current levels.  One bad day per month was relatively mild compared to the previous five-year period from August 2007 to August 2012. Bad days with greater than 2% declines occurred more than once a week!

I wondered if a bad week telegraphed a long term severe decline in stock market prices. Let’s say that within five trading days, the stock market fell 10%, averaging more than a 2% decline on each of those five days. I started my search twenty years ago and each bad week had its own story.

The list:
the LTCM financial crisis of October 1998,
the end of the dot com boom in April 2000,
the week following the attack on 9-11,
the bankruptcy of giant WorldCom and other accounting scandals in July 2002,
the winter months of 2008-2009 during the financial crisis,
the budget battle and fears of the U.S. government defaulting on its debt in August 2011, and the devaluation of the Chinese yuan in August 2015.

In each case investors were jolted by a surprise or some ongoing concern deepened into despair and a rush for safety. In some cases, the crisis ended or a solution was found and the dip was a good buying opportunity. In other cases, the fears signaled a severe and sustained repricing as in 2000–2003 and in 2008-2009.

Let’s say I interpreted a 10% dip as a good time to increase my equities. Imagine the sinking in my belly when stocks continued falling another 20, 30, or 40% as in the two repricing periods above. How could I have been so stupid?

Just as losses of 10% in a week are not reliable predictors of doom, gains of 10% in a week are inconsistent predictors of a market recovery. When bad weeks happen, financial pundits seem so sure that a 50% drop in the market is imminent. The data shows that this is not the case.

Now I’ll turn up the dial and see if I can find any consistency. A drop of 15% in a week is rare. In sixty years, the only instances of this are in October 1987, and October and November of 2008. In each case, there was more pain to come after that initial fall. So, if I happen to be alive when the next 15% weekly drop comes, the market has probably not finished correcting. The only 15% gain in a week was in November 2008, following an almost 20% fall the previous week. Boy, those were the good old days – not.

Since historical data does not give a clear guide for short to mid-term outcomes, my best strategy in reaction to a bout of market darkness may be – gulp! – do nothing. That can be so difficult when I am bombarded with forecasts of catastrophe at those times.  The sun will shine again.  It’s only an eclipse.

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