The Anatomy of a Stock Market DownturnWe Investigate Past Stock Market Declines to Get a Sense of What the Next One Might Look LikeTony YiuBlockedUnblockFollowFollowingJun 7If you would like to run your own analyses using my code, you can find it on my GitHub here.
Ten years in, this bull market continues to chug along despite interest rate rises, inverted yield curves, Trump tweets, European economic issues, and trade wars.
But these days if you chat with five people about the stock market, you will probably get five different opinions on where stocks and the economy are headed.
But no matter what your personal opinions are and how you are currently positioned, it is helpful to think about what the end of the party may look like.
In this post we will take a look via Python EDA (Exploratory Data Analysis).
“Fortune favors the prepared mind.
” — Louis PasteurExamining Market DeclinesIn my opinion, the qualitative impacts of a stock market crash and/or recession are much more important than their immediate quantitative impacts on your portfolio.
Dollars lost can be gained back over time but the psychological trauma and stress that a market crash can inflict is much longer lasting.
The memories of bad times continue to harm generations of investors long after the economy starts to boom again — through fear of the stock market and excessive risk aversion when facing financial decisions.
That said, it’s definitely useful to answer the question “How much do stocks go down during a typical market decline?” To do this, let’s take a look at the history of the S&P 500 (a good proxy for the U.
The following chart depicts the declines in the S&P 500 (i.
the decline in percentage terms from the previous all time high).
I am only looking at post World War II data because both the economy and the stock market have changed so much over the decades.
Also, the returns I use are price returns and do not include dividends (dividends provide a small amount of buffer from a market decline, which I want to ignore for this analysis).
Finally, I consider any negative monthly return, no matter how small, to be a stock market decline.
S&P 500 Decline from Previous Peak (Since 1950)A few interesting things jump out:There have only been three instances since 1950 where the S&P 500 declined by more than 30%.
However two of those (The Dotcom Bubble and The Financial Crisis) have occurred within the past 20 years.
The 1970s were a terrible time for investors.
This was when crude oil prices skyrocketed, inflation and interest rates regularly clocked in at 10% plus (the Federal Reserve targets 2%), and unemployment stayed stubbornly high.
In contrast, the 1990s (before the Dotcom Bubble burst) and 2010s (post Financial Crisis up to the present day) have been remarkably calm, allowing the market to consistently notch new all time highs.
These periods of extended calm seem to be more the exception than the rule.
The subsequent recovery to big market crashes (a decline of more than 20%) unfold slowly, often taking several years to recover the previous all time high.
Usually these big declines are accompanied by an economic recession.
Smaller market declines (a decline of less than 20%), on the other hand, are recouped rapidly usually within a few months of the market trough (as market participants realize whatever “stock market bogey man” they were panicking over was not real).
A Deeper Dive Into the NumbersAll in all, I looked at 820 months of data (from 1950 to the present).
Out of those, 282 months (34% of the observations) had negative stock returns.
And the single most negative month was October 2008 with a 20% decline (this occurred during The Financial Crisis).
However, most declines last longer than a month — the average length of a market decline was 3.
8 months in my sample.
So instead of just looking at each month by itself, it’s more illuminating to focus on the entire peak to trough decline whether that be one month or multiple months long.
The following table examines these peak to trough declines across several metrics.
Average Peak to Trough Decline measures the average peak to trough percentage decline of the S&P 500 (not including dividends).
Duration of Decline measures the average length of time in months between the previous all time high and the current market decline’s trough.
Duration of Recovery to Previous High measures the average length of time that the stock market took to go from trough to its next all time high.
Metric Comparison for Market Declines of Varying MagnitudeLet’s plot the observation frequencies (Number of Times Observed in the table) as probabilities.
In most instances (71% of the observed market declines), markets experience at worst a 5% decline.
And the overall average decline of 6.
1% is not too bad.
But if we just focus on the times when the S&P 500 declined by more than 5%, things look significantly more dicey:59% of these times, the market decline was 10% or more and 27% of the time the market crashed by 20% or more!So when markets decline by more than 5% we need to be cognizant of the fact that they may continue to decline and potentially crash.
Please note that we are working with small samples here so there is a lot of noise.
Historical Probabilities of Market Declines of Varying MagnitudeFrom our table above, we can also clearly observe two types of market declines (visualized in the column graph below):Smaller declines followed by quick, sharp recoveries.
Scary stock market crashes that take multiple years to recover from.
These losses take much longer to recoup because big market crashes usually come hand in hand with a recession, tightening bank credit, investor despair, and lots of bankruptcies.
Remember that I omit dividends in my data.
With dividends (especially if you reinvest them), the recovery period is shortened somewhat.
Market Crashes of -20% or Worse Take Much Longer to Recover FromFinally, note from the chart above that during larger declines, the S&P 500 takes its time finding the bottom (the blue columns).
So if you are trying to buy low, do so gradually and with discipline.
Most likely you will end up buying some and then watching as the market declines another 5% over the next month (at which point you can buy some more).
High Flying Stocks Fall Back to Earth During CrashesFinally, let’s look at how the stock market darlings of yesteryear fared in either the Dotcom Bubble crash or the Financial Crisis to get a sense of how today’s high flyers such as Netflix or Okta would perform during a significant market downturn.
During the late 1990s at the height of the Internet Bubble, leading tech companies like Microsoft and Cisco were on top of the world.
Then the bubble burst and investors who owned these shares lost a ton of money:Ouch!In 2008, on the eve of the Financial Crisis, Apple was just a year removed from releasing the iPhone and Bank of America was one of the largest and most profitable banks in the world.
Then the housing bubble burst and the global financial system almost went under:Bank Stocks Got Crushed in 2008In both cases, the most popular stocks of the day declined more than the overall market during the crash.
However in 2000, it was tech stocks that were the most overvalued and thus they declined significantly more than the overall market.
Meanwhile in 2008, it was the banks that were sitting on a financial house of cards and so bank stocks took the hardest beating in the ensuing economic recession.
Key TakeawaysMost market declines are small and quickly recovered.
Even a 15% decline is recovered on average 5 months after its trough.
I guess there is some wisdom to “buying the dip” after all.
Stock market crashes (declines of 20% or more) are much more painful not only in terms of the magnitude of the decline but also because it takes on average 1.
5 to 4.
5 years to recover from the damage.
It sounds obvious when I say it like this — but we are significantly more at risk of of a market crash in situations where the S&P 500 has already declined by at least 5%.
Concentrated positions in the most popular stocks of the day are risky in the late stages of a bull market.
These high flyers are punished significantly more so than the overall stock market during a crash.
During market declines deploy money gradually and with discipline.
In a serious decline, the stock market takes at least several months to hit bottom so there should be ample opportunity to average in over time.
And if like in most cases, the market pops back up rapidly, don’t FOMO because you didn’t get to deploy all of your cash.
There will always be more buying opportunities down the road.
Good luck!Further ReadingDo Stocks Provide a Positive Expected Return?Do I Have Enough Money to Retire?.