"[E]very time stocks begin to fall there’s a little voice in the back of our heads that tell us, 'Maybe this is the big one…'” – Ben Carlson
October has been a month that most stock market investors would rather forget. At one point last week, all three major US stock market indices (S&P 500, Nasdaq, & Dow Jones) had given up all their year to date returns. The old adage that “stocks take the stairs up and elevator down” has definitely been the case in 2018. The pickup in volatility and pull-back from the recent high has everyone asking where the market is going from here.
If you’ve been a follower of our blog for any amount of time, you already know we are categorically against making predictions about the future and rely heavily on systematic based strategies to guide our investment allocations. That being said, we also understand that periods of market turmoil, like we are seeing this month, have the potential to cause some anxiety. As we’ve written before, the human brain is wired to assign a cause to every effect and drops in the market are no exception. Unfortunately, when it comes to something as complex as the stock market, trying to assign a cause to every effect may be nothing more than a fool’s errand. Cullen Roche summarized this sentiment nicely in a recent post.
Whenever the stock market falls, people wonder why it’s happening. There are always lots of creative stories, and they’re probably right to some degree, but the reality is that the stock market is like a mutating organism whose changing mutations have ever-changing causes. We don’t really know what causes it to change each time, and we can’t necessarily use past understandings to predict future changes. Still, we make up these narratives because they give us the illusion of control in an otherwise opaque world.
Of the “creative stories” and “narratives” that I’ve read over the past couple weeks, I would say some of the most compelling arguments for the market sell-off are consumer confidence simply being stretched too far in the positive direction coupled with the fact that the Federal Reserve continues to raise interest rates which reduces liquidity by making it more expensive to borrow money. On the bullish end of the spectrum I’ve also read compelling arguments for why this correction is not the start of a prolonged bear market because of the Trump tax cuts, record low unemployment, and the fact that the economy is growing faster now than it has at any point during the current bull market.
So which is it, a simple correction in sentiment or the start of a nasty bear market? The simple answer is we don’t really know. One thing we can do is look back through history to see how many times a 10% sell-off turned into a bear market versus a simple correction. Ben Carlson, who we quoted to open this post, recently did such a study. The chart above summarizes his findings which shows that 27 out of 47 times (roughly 57%), when the market goes down by 10% it ends up rebounding and not turning into a bear market (20% or more drop). The average correction (greater than 10% but less than 20% drop) over this time period was a drop of -14% which lasted 132 days from peak to trough. The average bear market (greater than a 20% drop) was a drop of -37% over 358 days.
Some may find comfort in that statistic knowing the odds of a rebound our in our favor while others may focus on the 43% of the time that things get worse before they get better. The fact of the matter is nobody knows what the future will look like. All we can do as investors is have a plan in place that dictates how we will react to times of market turmoil. Whether that plan is buy-and-hold, a trend following discipline, stop losses, or something else, it is important to “stick to your knitting” in times of turmoil and not make knee-jerk decisions. As Warren Buffett likes to say, “You only have to do a very few things right in your life so long as you don't do too many things wrong.” Don’t let second guessing an investment discipline during times of uncertainty be one of those too many things you do wrong.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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