As coronavirus-linked fear and uncertainty create havoc in the stock market, it’s easy to lose perspective and let your worst instincts prevail. All the more so if you let the new headlines du jour dominate your outlook. In that case, the sharp slide in equity prices can seem extraordinary in the extreme. But at times like these it’s crucial to maintain perspective from a historical standpoint. There’s no way to sugarcoat what’s been unfolding—and it could get worse. But it helps to step back and consider previous bouts of high volatility in the stock market to see how the current correction compares.
Let’s start by looking at drawdown—the peak-to-trough decline. Because the market (S&P 500 Index) reached a record high only last month, the unusually sharp decline has been stark. But for all the sturm und drang, we’ve been here before—and then some.
The boxplot in the first figure below shows the current S&P 500 drawdown: -27.8% as of March 24, per the red line, which provides some historical context (since 1951) for the recent correction. The box shows the interquartile range of drawdowns (the 25th to 75th percentiles). Statistically speaking, this is where most of the drawdowns cluster, with the median at -5.7% (blue line). The main takeaway: the current drawdown of nearly -30% is much deeper than usual. But even darker shades of red ink aren’t unprecedented. Mr. Market’s gloom at one point left the S&P 500 nearly 60% below its previous peak in an earlier decline.
Figure 1: Range of S&P 500 Drawdowns, 1951–2020
Source: James Picerno
Perhaps the most important question to ask: Does the market’s slide create buying opportunities? In a word, “Yes,” although the details are messy. Buying low boosts the odds that expected return is relatively high. But as the Capital Group reports, market downturns of -20% or deeper last, on average, 401 days in terms of regaining the previous peak.
No one can identify the bottom in real time, of course, and so it’s never obvious when it’s “safe” to deploy new capital into a beaten-down market. Nonetheless, at some point the selling will end and a rebound will begin. Timing, however, remains unclear—all the more so given the unusual trigger of the current bear market: a global health crisis.
Nonetheless, earlier this week Vanguard estimated that the 10-year expected return for the U.S. stock market increased to 6.8% (annualized), based on the median simulated projection for the firm’s model, as of March 12. That’s up from 4.4% forecast at the end of 2019. What changed? The market’s valuation has fallen in the recent crash, “giving equities more room to grow before they reach what we’d consider to be their fair value,” advises Joe Davis, global chief economist at Vanguard.
Another way to measure relative value is with a metric known as the CAPE ratio (Cyclically Adjusted PE Ratio), which is updated by Professor Robert Shiller at Yale University. The latest estimate of the CAPE ratio is 23.2 (as of March 12). That’s down from recent highs (above 30 in late-2017 and early 2018), but 23.2 still well above the long-term median of 16.3 (see Figure 2). In other words, it appears that it’s still premature to say the market is inexpensively priced, at least by this metric.
Figure 2: S&P 500: CPE Ratio vs. Subsequent 10-Year Return
Source: James Picerno
Keep in mind that history tells us that lower CAPE ratios tend to align with higher returns over subsequent 10-year periods. But market history is messy, especially in the short run. There have been cases when buying at a relatively low CAPE ratio didn’t insulate investors from negative 10-year results.
While there are no guarantees, a lower CAPE is still better, in that it implies higher returns. If the market continues to decline, the CAPE ratio will follow, potentially offering even more attractive expected returns (assuming you can wait out any remaining near-term market volatility).
Market valuation doesn’t mean much for shorter-term horizons, which leads some investors to look for clues about expected returns in drawdowns—especially when peak-to-trough declines are sharp and steep. But history paints a mixed profile on this front and so caution is warranted. For example, the relationship between the depth of the drawdown and the subsequent one-year return for the S&P 500 is all over the map. That said, the odds do tend to skew positive for high one-year expected returns once drawdown falls below -30% (see Figure 3). In other words, if the market continues to decline, the case will strengthen for expecting a significant near-term pop at some point.
Figure 3: Range of S&P 500 Drawdowns vs. Subsequent 1-Year Return, 1951-2019
Source: James Picerno
It’s even more important to manage expectations for longer-run horizons. Here, too, history can help. For example, the rolling 10-year annualized return since 1961 has experienced wide swings and there’s no reason to think that the future will be any different. But for the moment, the performance for this trailing window is comfortably positive. Despite the market upheaval in recent weeks, Figure 4 shows the S&P 500’s current trailing 10-year annualized return of roughly 7.8% (as of March 24) is close to the post-1961 median of 7.3%.
Figure 4: S&P 500 Rolling 10-Year Annualized Total Return
Source: James Picerno
Mr. Market, in short, is a volatile chap. A month ago he was handing out trailing 10-year returns in excess of 12%. That’s been cut nearly in half after the latest selling wave. Disappointed? Sure, who isn’t? But it was always folly to think you’d earn 12%-plus from the S&P 500 through the end of time. History suggests something on the order of 4%–6% is a more reliable estimate.
The good news is that the expected return will rise if Mr. Market’s depression deepens from here. The danger is selling out at or near the point when expected return has surged to historically high levels (a.k.a. sharply lower prices).
Mr. Market can be quite generous at times, but he can be cruel as well. The first order of business is learning how to navigate and survive his dramatic mood swings by managing expectations via studying market history. The past doesn’t repeat, of course, but it does tend to rhyme. And so it’s critical not to let whatever tune Mr. Market’s singing today divert us from listening and learning from the full opera.