Stock prices have fallen recently and we wanted to touch base. Figuring out how the economic impacts of a global health crisis will play out is a challenging task. The market has responded by pricing in lots of new known information and lots of big unknowns. Uncertainty increases risk, driving down asset prices, and driving up expected returns. Periods like this are expected from time to time but they are also painful to endure.
Market drops are scary; the narratives that accompany them can be scarier. The narrative does not change the facts of the situation but it can easily change how we respond to it. For example the 1920-1921 US recession was surrounded by World War I, the 1918 influenza pandemic, and a public fear of communism. Combined, these were the basis for an unsettling narrative of economic uncertainty.
Based on how the world looks today the influenza pandemic of 1918 might be of particular interest. The 1918 flu is estimated to have killed 675,000 people in the United States and 40 million people around the world from the spring of 1918 through the spring of 1919. Males aged 18 to 40 were hit the hardest. Between the sparse available economic data and anecdotal evidence from newspapers we can estimate that the major economic impacts were a reduction in labor supply resulting in a higher cost of labor, and a short-term but substantial revenue reduction for businesses, particularly in retail and entertainment.
We cannot say with certainty if the recession that followed was caused by the flu or the confluence of other factors but we do know that the S&P 500’s cyclically adjusted price earnings ratio dropped to its lowest level in history in December of 1920. Following that drop, asset prices quickly and aggressively rebounded. We aren’t saying that you should expect a rebound tomorrow, but rebounds after crashes have been historically persistent.
In a 2017 paper titled Negative Bubbles: What Happens After a Crash William Goetzmann and Dasol Kim studied stock market crashes from 101 global stock markets from 1692 to 2015 and identified 1,032 events where a market declined by more than 50% over a 12-month period. They found that the probability of a large positive return was higher following a crash. This is important if now seems like a good time to change your strategy. The 1,032 crashes in Goetzmann and Dasol’s paper were probably accompanied by intimidating reasons to expect worse things to come, but today we can step back and observe the outcomes, free from the accompanying narratives.
These data highlight the importance of sticking with the plan. If we get out of the market to avoid a drop, or after a drop, we also need to get back in. Getting back in at the wrong time might mean missing out on the rebound gains.
We can use the S&P 500 going back to 1926 through the end of February 2020 as an example. It returned a whopping 10.08% per year on average in US dollar terms over the full period. If we remove the top 10 monthly returns, that is the top 0.9% of months in the period, the annualized return drops down to 7.74%. But here’s the tricky part: most of those top returning months occurred during or after big drawdowns. If you got out, you may have missed out.
At a fundamental level we need to keep a view of what stocks are. When you buy stocks you are buying ownership of expected future earnings from real businesses. You pay a price for those expected earnings based on how risky the businesses are. When stock prices drop, it means that expected future earnings have decreased, businesses are riskier, or some combination. To lose all of your money in a globally diversified portfolio of stock index funds we would need to be in a situation where nobody expects any business to earn any profits in the future. This is an extreme case, and it seems fairly unlikely.
It’s probably more realistic to watch your portfolio decline, maybe substantially, for a period of time. This is where narratives and asset allocation become equally important. Narratives will make us believe that this time is different; while the narrative might be different, challenging and uncertain times are nothing new.
Just this century we have seen the dot com crash, the 9/11 attack on the world trade center, Ebola, the Swine Flu, SARS, the Global Financial Crisis, and the start of COVID-19, while the MSCI All Country World Index delivered an average annual compound return from January 2000 through February 2020 of 6.56% in Canadian dollar terms. We are not saying that this time is not different – we are saying that investors have a long track record of being compensated by positive expected stock returns in exchange for taking risk.
Narratives are powerful and often important, but they can affect the way that we interpret facts. We think that it’s important to step back and look at the broader set of data before responding to a meaningful decline in stock prices. We are not saying that this won’t be hard. The market might keep dropping. After each subsequent drop the decision not to sell after the previous drop might seem regrettable. Everything is obvious in hindsight.
On any given day, including after a market drop, the best thing that we can do is stick to the plans that we made in calmer times. The economy might take a big hit, but this is why you had an emergency fund. Stocks might continue to drop, but this is why you invested in a risk-appropriate portfolio and stress tested your financial plan.
In the moment, when things are uncertain, it can be challenging to make good long-term decisions. This is why you made a plan, and now is the most important time to stick to it.
