The annoyance of a good example

Few things are harder to put up with than the annoyance of a good example.

— Mark Twain

Every market downturn in history has ultimately led to a subsequent upturn, and this time was no different. From peak to trough earlier this year, the S&P 500, S&P/TSX, Nasdaq. and MSCI EAFE Indices fell approximately 34%, 37%, 30%, and 34% respectively. In our “Big bears or baby bears?” Investment note, published in early April, we examined past recessionary bear markets and segmented returns 1, 2, and 3 years following S&P 500 Index declines of 10%, 20%, 30%, 40%, and 50% from the peak. The heatmap below illustrates that the true buying opportunity (whereby gains were 1–2 years out) didn’t occur until equities were -30% or more from their respective peaks. This time was no different in terms of returns from the bottom. The S&P 500, S&P/TSX Composite, Nasdaq Composite, and MSCI EAFE Indices have risen 52%, 46%, 63%, and 41% respectively from their lows through to September 15.

The annoyance of this good example is that during the month of March, investor behavior was once again driven by emotion, which led to poor investment decisions. South of the border, investors pulled US$326 billion from mutual funds and ETFs, more than three times the US$104 billion in outflow in October 2008 during the Great Financial Crisis. The Canadian mutual fund industry had its worst month ever, in dollar terms, as it saw more than CAN$14.1 billion in net redemptions.

Admittedly, where we were wrong was the speed of the recovery. In our “Big bears or baby bears?” note, we highlighted how long it took for investors to break even on their initial investment once the markets had bottomed during previous recessionary and non-recessionary bear markets. The chart below illustrates the median and average trading days it took for an investor to break even after investing at drops of 10%, 20%, 30%, 40%, and 50%. For example, after a drop of 10% from the peak, on average, it took approximately 730 trading days to break even from a recessionary bear market versus 138 in a non-recessionary environment. There are approximately 250 trading days in a year, so this suggests an investor who bought at the first 10% dip during a recessionary bear market may not see a return on that investment for almost three years.

This time was an anomaly compared to previous examples; it only took 61 days to break even after a drop of 10% from its peak on February 19 after bottoming on March 23. This can be credited to unprecedented fiscal and monetary support from governments and central banks. As of the end of July, global central banks had cut interest rates 164 times in 147 days and committed US$8.5 trillion in stimulus. The global fiscal support was also swift and astonishing. Direct budget support was US$4.4 trillion globally, and additional public sector loans and equity injection, guarantees, and other operations amounted to another US$4.6 trillion, according to the International Monetary Fund. But then again, this has been anything but a normal recession, and the unprecedented response can explain the speed of the rally.

Where do we go from here? The pullback in equities over the past couple of weeks shouldn’t have come as much of a surprise to investors. We’ve yet to see whether this will turn into a full-blown correction; regardless, the ingredients are there: a seasonally weak period for stocks, valuations (particularly in the technology sector — as an example, towards the end of August, Apple’s market cap was equivalent to the entire FTSE 100!), and an upcoming U.S. election that’s very likely to be contentious. We highlight these three factors in a recent Investment note, “IT couldn’t go on forever.” The good news is that the odds of a recession over the upcoming year are low, as social distancing measures, masks, and advancements in COVID-19 therapeutics mean we’re better prepared for potential future outbreaks and won’t likely be required to completely shut down our economies like February and March.

Over the past 30 years, there have been 25 corrections in non-recessionary environments (pullbacks of 10% from their previous high), the one-year forward returns that followed have averaged a gain of 20%. The most recent example was the fourth quarter sell-off in 2018. On October 29, 2018, the S&P 500 was down 10%, but despite a further 10% drop, that one dollar invested on October 29 was up 15% one year later.

Few things are harder to put up with than the annoyance of a good example unless you take advantage of it. The good example in this case is that in a non-recessionary environment, investors who either increase their equity weights or deploy cash are often rewarded when markets correct. It’ll be important in the coming months to remove emotions from decision making and focus on your long-term goals. Avoid selling investments when markets are low to take advantage of potential market volatility.

Macan Nia, CFA
Senior Investment Strategist