Investors should be thankful that stock markets go down

Published in The Sunday Times on February 20th 2022

It’s been a rocky start to the year for global equity markets. After a prolonged period of relative calm and strong returns, this may come as a welcome development for investors with cash to deploy. 

I am not the superstitious type, but I’ve often used the expression, ‘be careful what you wish for’. For stock market investors, such caution should be thrown to the wind. All investors should be thankful that stock markets go down. Here’s why…

Volatility and short term loss are necessary – it’s like a fee

If stocks always went up, they wouldn’t be risky —and their returns would end up being paltry. Stock markets demand a price and they extract that payment in the currency of uncertainty, short-term loss, fear and regret. The short-term pain of loss is the explicit price we pay for the potential for meaningful long-term returns. This is easier to accept in theory, than to follow in practice.

Morgan Housel, of the Collaborative Fund, advises that we should consider these periodic bouts of stock market weakness as a fee. Fees being something you pay for getting something valuable in return. As opposed to considering the stock market’s gyrations as a fine – a punishment which is something to avoid. This isn’t just semantics, it’s an important distinction. If we agree to pay the fee, we expect it and won’t waste time giving it further thought. A fine carries emotional baggage. It’s not inevitable and we will be inclined to waste too much time trying to avoid it.

But let’s indulge this emotion and consider the tantalising prospect of avoiding stock market sell offs. Afterall, some of them can be brutal and well worth side-stepping. 

Is it possible to side-step market corrections?

Stock markets tend to go up most of the time, punctuated by occasional sharp falls – usually associated with recessions. The term occasional has important implications. Betting against a more persistent trend – a rising market - suggests you are likely to be wrong more often than right. But it’s not the frequency with which you are right that counts, it’s the payoff that matters. So let’s examine that.

An important, and relatively simple concept taught in business classes is the concept of expected value. If there’s a 50% chance that you will win €20, and a 50% chance that you will lose €10, then the expected value of your winnings is €5. This is true even though there is zero chance of you winning that amount (you will either win €20 or lose €10).  

When you look at the history of stock market returns, the average yearly return (for the S&P500) has been just over 10% since 1926 (assuming you reinvested all dividends).   The most common annual outcomes are returns between 10% and 30%, while a loss of up to 20% is considerably more likely than a return in the 0 to 10% range (where most forecasts lie). 

So an “average” 10% year, is actually quite rare.  The markets’ tendency toward over-excitement and over-despondency looks like it provides fertile ground for market timing. 

A small number of days usually decide an entire years’ return

The harsh reality is that the stock market’s annual return is decided by an unusually small number of days each calendar year.

According to Crestmont Research, in both bull markets and bear markets over the past century positive return days represent between 45% and 55% of the days. So most days’ returns offset each other. So regardless of the total return for the year, a small number of the most extreme days will total up to equal the net return for the year--whether positive or negative. In short, timing this is a low-odds undertaking.

There’s a caveat. Historical references herein to previous cycles are only helpful in so far as the circumstances today are representative of those that prevailed (on average) historically. And arguably today looks quite different to the average. Global stock markets, particularly the US, are trading on a hefty valuation premium. Interest rates at historical lows will provide some succour to the bulls. But that pillar has been on shaky ground recently. 

When valuations are stretched you can try to tilt the odds in your favour

At today’s price relative to a more normalised earnings ratio, forecast returns look a lot lower than the long-term average. That’s not to suggest market valuation is straight forward. It isn’t. 
According to Bank of America, valuations explain very little of returns over the next one to two years, but they have explained 60%-90% of subsequent returns over a 10-year time horizon. 

The best we can do is try to tilt the odds in our favour. When the market is offering us favourable odds i.e. when forecast returns look better than average - we should be prepared to be bold. Likewise, we should keep some dry powder for the periods when the pendulum has swung too far in the opposite direction. 

What you wish for won’t make a jot of difference to the returns you get from the stock market. But we definitely shouldn’t wish away periods of volatility. It normally takes a recession for stock markets to cough up significant returns, but who knows? This one may yet provide an opportunity to be bold.