How unusual are today’s markets?

Well, the year has certainly got off to a bang. And, unfortunately it’s the bad sort of bang. The US equity market (S&P 500) has fallen -10.5% peak to trough from its December high and the European equity market (Euro Stoxx 600) has fallen over -16%. We think the fact that this happened at the start of the year meant it has garnered broader press attention than usual. We will talk briefly later on about our take on these falls and whether they are an opportunity or a harbinger of something worse. However, first we wanted to have a look at how unusual falls of this magnitude actually are? Is “equity market goes down” a genuine news story or just a fact of life for what has always been a volatile market?

To answer this we ran the numbers on the US S&P market from 1931 (we used the US market as it has longest continuous price feed available on Bloomberg). We counted the amount of times the market fell by more than -10% (and started counting again when it had recovered by 5%). Our results in chart form are below.

spx drawdowns

We count that there have been 116 drawdowns of 10% or more in the 84 years since 1931. This is an average of 1.4 a year. This makes the three years of 2012 to 2014 (when there were none) unusually quiet and the last 12 months (when there have been two >10% drawdowns including the current one) more like a return to normality. However, you’ll see there was a real concentration of losses in the 1930s, a period which encompassed the great recession and the run up to World War II. If we take this out and start counting after the end of World War II then we get 74 drawdowns in the last 70 years, or about 1 a year.

The bottom line: current market moves look very normal to us and are consistent with historical experience. We have heard people argue that we were due a correction after a recent unusually calm period. We have some sympathy for this view but also take a look at the early 1990s when calm reigned for much longer than we have seen recently. This can make sitting on cash and waiting for the next inevitable fall a costly strategy (though you will inevitably feel clever when it finally happens!)

The question is then is the market telling us that something bad lurks round the corner or is it time to be a wise head and add to positions you like at cheaper prices. We believe the main worry is whether the US economy will keep slowing down and tip into recession. In this scenario a 10% fall in equities would probably just be the start of something much worse. We see three ways the market thinks we could get there. First, the ongoing slowdown into China and emerging markets spreads to developed markets. Second, the collapse in oil triggers falling capital spending on energy (so lowering growth) and rising credit costs (as energy companies start to default). This means a slowdown in corporate spending and a broader credit crunch. Finally, interest rates in the US rose at last in December and are expected to rise again this year. This would only add to any tighter credit environment.

Short term we think these fears are overdone. Positioning and sentiment have reached extreme levels and the market seems more likely to bounce from here especially if (and it’s a big if) oil is able to find a bottom. We also think the situation is more contained and not as bad as the pessimists like to make out. Longer term, the picture is not as clear. Here is Larry Summers (the former US Treasury Secretary) talking recently about the ability of economists to predict them:

The Economist had a remarkable statistic. The IMF makes forecasts for every country every April. There have been 220 instances across several decades and some number of countries where growth was positive in year T and negative in year T+1. Of those 220 instances, the IMF predicted it in April in precisely zero of those 220 instances. So the fact that there’s a sense of complacency and relative comfort should give very little comfort.

We therefore remain far from complacent. Our risk levels are fairly neutral. If we see US recession risk rise it will be time to reduce our risk levels further.