Have We Seen the Market Bottom, Or Will It Get Worse for Stocks? : January 2, 2019

The end of 2018 was a difficult period for investors, with the U.S. stock market declining nearly 20% since its peak in September, and returning -4.4% for the year. Stocks outside the U.S. had an even tougher year, with returns of -14.2% in 2018.

The big question on the minds of investors today is: have we seen the market bottom, or will it get worse for stocks? The truth is, no one knows with any degree of certainty, but here’s some advice as to how to think about the recent volatility and help put our fears and concerns in perspective.

Downturns are a normal part of investing

Remember that declines in stocks of this magnitude occur quite regularly, and they don’t last forever. If we look back at the U.S. stock market since 1950, declines of more than 10% have occurred about every couple years on average. They had an average drawdown of 19.6% and lasted an average of about 7 months from peak to trough. 

Declines of 20% or more have occurred about every 8 years on average. These had an average decline of 35.7% and lasted about 14 months on average. 

The biggest downturn since 1950 was during the financial crisis in 2008, when stocks declined 56.8%, which lasted about 17 months. That was also the last time we had a decline of over 20%. The longest decline occurred after the tech bubble in 2000, when the market declined 49.2%. That downturn lasted 2 ½ years.

Nevertheless, an investment of $10,000 in the market in 1950 would have grown to over $10 million today. This assumes dividends were reinvested, and represents a 10.9% annualized return. To earn this return, investors would have had to endure 36 downturns of more than 10%, nine of which were declines of more than 20%. 

Reward doesn’t come without risk in investing, and at the end of the day downturns in stocks are the price we pay for expecting higher returns over the long term.

Avoiding downturns is hard

Some investors may look back and believe that they saw this last drop coming, and kick themselves for not having sold last Summer. Others may sense that we are about to see a further decline in stocks, and want to sell before the next downturn occurs. 

The reality is that things always appear more certain in hindsight, and no one has a crystal ball when it comes to markets. Strategies to time markets are frequently tried but rarely successful, and trading on one’s gut instincts is always a terrible idea. 

Each year companies like DALBAR and Morningstar publish studies showing that the average investor underperforms the market by as much as 4% a year. This underperformance is mostly due to poor timing decisions, causing investors to miss out on a disproportionate amount of the market’s gains. Studies show that just missing the market’s 10 best days over a 15 year period can cut your returns in half.

One of the challenges with avoiding downturns is that you need to be right not just once, but twice. Not only do you need to be right about when to sell, you also need to be right about when to get back in. 

Think of the countless investors who were lucky enough to sell before the financial crisis in 2008 (or unlucky enough to sell at the bottom in 2009), yet remained in cash throughout the recovery expecting that markets would soon fall further. Those investors missed out on over a 300% return in stocks since March of 2009. Sitting on the sidelines costs more than riding out bear markets.

Aldous Huxley’s “law of reverse effort” is the idea that the harder we try, the worse things get, and this principal often applies in investing. Like trying to escape quicksand, making changes to your portfolio to avoid market downturns is more likely to make things worse over time.

Things aren’t as bad as they seem

The list of things to worry about right now seem to be endless: rising interest rates, growing trade tensions, the government shutdown. There are always things to worry about when it comes to investing, and while we can’t predict where things will go from here, the situation is not as bad as it may seem. 

Many observe that the volatility we’re seeing is reminiscent of some of those ugly periods, like at the start of the dot-com crash in 2000 and financial crisis in 2008. Yet we don’t have the kinds of systemic problems we had then, like insane valuations in the tech sector, or a bubble in subprime mortgage loans. 

Looking at economic data in the U.S., there is nothing to indicate that we’re headed into a recession or another bear market for stocks. GDP growth remains strong at 3.4%, labor productivity is increasing, the unemployment rate at 3.7% is the lowest in 50 years, and inflation continues to remain subdued at 2.3%. With a growing economy, strong employment and spending growth, and with moderate oil prices and interest rates, the U.S. is positioned to ride out any storms. 

Look beyond the headlines

As in previous periods of market volatility, there will be no shortage of eye-catching headlines and gripping commentary from Wall Street pundits covered in the news. Remember, sensational headlines and narratives drive profits in the media world, and that gripping commentary is often connected, either directly or indirectly, to a product or service that pundit is ultimately trying to sell or draw attention to. 

As Morgan Housel writes: “The business model of the majority of financial services companies relies on exploiting the fears, emotions, and lack of intelligence of customers. The worst part is that the majority of customers will never realize this.” 

Your best bet is to limit your media consumption as much as possible, focus on sources you trust to be objective, rationale and balanced, and tune out the rest.

Plan instead of predict

Rather than spending energy on things you can’t predict or control, like what the economy or stock market is going to do next, focus on having an investment plan that is durable enough to weather a variety of market outcomes. A plan that gives you the best odds of success without having to guess the exact market outcomes in advance. 

That includes having the right balance of cash and high quality bonds to get you through an inevitable downturns in stocks. If this recent downturn made you jittery, perhaps you have more invested in the stock market than you should, and now’s a good time to reassess your capacity for risk and plan to adjust accordingly.

Also, remember to focus on ways to impact your wealth that go beyond your investment portfolio, like budgeting, reducing taxes and estate planning. A few carefully considered planning strategies can change your situation in a way no diversified portfolio can on its own.