The Agony and the Ecstasy: The Return of Volatility

Looking back in history, there have been larger market declines, but the remarkable thing this time is how quickly the market mood changed from ebullient to fearful. This swing has been the most abrupt momentum change for U.S. stocks in history. Putting aside the technical details, there is a standard measure of the market’s direction – essentially the pace of price changes in the market. It follows then, that one can measure the change or “swing” in the market’s direction over a short period of time. On February 8^th, the two week negative swing was the largest in the history of accurately measuring stock market moves (going back to 1930). ⁽¹⁾

A Brief History of Rapid Declines

So, what does history tell us about what could be ahead for investors? For this, we are grateful for the data that Sid Mokhtari of CIBC World Markets has pulled together on rapid market declines. Looking back to 1950, there have been a total of 61 rapid decline events in the S&P 500, as defined as a 10% or more pull back in the market that occurs within 10 trading days. As one might imagine, in a bout of volatility, a number of rapid decline events that meet the “10% decline in 10 trading days” definition may follow in close succession. Removing these multiple events, it turns out that there have been only 11 prior rapid decline periods, as summarised in the exhibit.

A number of points can be drawn from this history.

• First, these rapid decline periods are quite rare – 11 times in the past 68 years isn’t very much. You can easily identify Black Monday (1987), the Asian Contagion (1998), 9/11 (Fall 2001), and the Global Credit Crisis (2008/09), and you may recall some of the others. Note that a rapid decline period doesn’t necessarily lead to a bear market, which is a declining market over an extended timeframe.
• Also, these rapid decline periods tend to occur a number of years apart, with the three 2001/02 events being the exception where three decline periods repeated with a gap of only several months.
• The duration of the decline period (the number of calendar days between the first and last rapid decline event) is quite short – although, of course, there will be a longer period of volatility and recovery that follows.

What Next?

Now that we have had a rapid decline event, what may lie ahead for investors? The history shows… “more agony and ecstasy”.

• The agony. After a rapid decline event has occurred, ongoing volatility for some time is typical. Once the market volatility has started, the roller coaster tends to last for a while. The roller coaster analogy is key here as the aftermath includes market ups and downs, so don’t get alarmed when we highlight only the downs. History shows that, following the first rapid decline event, there will be more downs, with the largest subsequent high to low in the following 12 months averaging an 18.8% decline. Bear in mind that these subsequent declines usually occur after a recovery, so the subsequent decline is not additive to the first 10% decline!
• The ecstasy. The good news part of the historical picture is that patience brings better times. After the 11 rapid decline periods, the S&P 500 climbed an average of 14.6% in the following twelve months including the effect of the roller coaster downs. For the three periods that still had negative returns at the 12 months point, extending the forward period led to better outcomes. This occurred promptly after the 1987 and 2008/09 periods. After the Fall 2001 period, the market took a little over two years to recover, but recover it did.

This increase in volatility is unsettling for investors. As indicated, there are some “general” lessons from history, but we also know that each time will be different. This time, here are some specifics to keep in mind:

• There has been an absence of any real negative news. Indeed, the world is enjoying a period of synchronised economic growth, corporate profitability is strong and rising, and recent corporate tax cuts in the U.S. will be stimulative. Rather, it appears that this bout of volatility was exacerbated, ironically, by the abrupt unwinding of the trading bets that many investors had placed which were collectively premised on the continuation of low market volatility. Ouch!
• Valuations, which appeared stretched at the end of 2017, are now more reasonable. The beneficial effects of the U.S. corporate tax cuts and weaker U.S. dollar have now been factored into earnings estimates, lowering valuation multiples.

We think the best defence in an environment like this is our usual Nexus mantra. 1) No one can reliably predict where the market is going in the short term, so keep a long-term perspective; 2) The equity markets go up over time and you need to be in the markets to benefit; and 3) Maintain proper diversification with a portfolio of quality companies at reasonable valuations.