Swedroe: An Awakening Bear?

October 15, 2018

Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.

—Peter Lynch

On Oct. 10, 2018, the S&P 500 Index fell 3.3%. The 11th wasn’t much better, with the index dropping a further 2.1%, producing a two-day loss of 5.4%. These drops occurred without any bad economic news. In fact, Federal Reserve Chairman Jerome Powell indicated it was the Fed’s view that the economic recovery was robust. And most economists are forecasting continued strong growth into next year.

Looking for an explanation, most market commentators blamed the drop on the expectation that the Fed will continue to raise interest rates. However, the market was already expecting several more rate hikes over the next year. Further, on the 11th, the news on inflation was benign, with the August Consumer Price Index increase at just 0.2%, producing a 12-month rate of just 2.3%. Other explanations were tied to trade-war concerns. However, all of these facts were well-known prior to the 10th, and nothing had really changed.

While markets often move for no apparent reason (think of the recent flash crashes we have experienced), it’s an all-too-human trait to seek explanations, to find patterns in what could be randomness. And that search for explanations can lead many investors to abandon even well-thought-out plans. Before you succumb to such an urge, I suggest you consider the following.

A good place to start is to see if there is anything unusual about the two days we just experienced. Such large moves in a single day might seem unusual. After all, over the past 92 years, stocks have provided annual average returns of about 12%. Thus, a more than 3% move in a single day is more than 25% of the average annual return. And the two-day move we experienced is more than 40%. However, stock returns are not normally distributed.

Distribution of Stock Returns

Benoit Mandelbrot and Richard Hudson examined the daily index movements of the Dow Jones Industrial Index from 1916 to 2003. They noted that if stock returns were normally distributed, a single-day price move of more than 3.4% would have occurred 58 times. The actual number of occurrences was 1,001, more than 17 times as frequently.

They found that a daily price move of more than 4.5% would have occurred just six times, yet it occurred 366 times, or 61 times greater than with a normal distribution. They also found that a daily price move of more than 7% would have occurred just once in every 300,000 years. Yet, it had occurred 48 times!

In other words, markets are risky, and returns exhibit excess kurtosis (the tails are much greater than would be expected if returns were normally distributed). Thus, we can conclude that large moves such as we have seen in the last two days are “normal” in the sense that they should be expected, although we cannot predict when they will occur.

It’s also worth noting that, according to Ken French’s data library, the U.S. market had negative returns of 106, 212, 402 and 367 basis points over a span of eight days in late January and early February. The other four days experienced either modestly negative or positive returns. In total return terms, the U.S. market fell 9.3% over that eight-day stretch.

To my knowledge, there is no evidence that such large drops forecast continued negative returns for the longer term. Considering the following evidence covering the period since the end of the Great Financial Crisis. I examined how the S&P 500 Index performed after a month in which it had experienced a drop of at least 5.0%, rounded to the nearest 10th of a % (roughly the size of the loss from Oct. 10-11). We have had six such periods.

The table below shows the returns over the succeeding six and 12 months. As you review the data, keep in mind that two of the episodes of losses of more than 5% in a month happened back to back (creating a hurdle for the period following the first of the two down months).


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