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What happens after the stock market drops?

What happens after the stock market drops?

October 2018 ran true to form by ending with a pronounced drop in the major stock market indices. In this article, we try to determine if history can teach us anything about this type of episode.

If you invest in the stock market by means of mutual funds*, it is likely that their value was down on October 31, 2018. In fact, last month the Toronto Stock Exchange index experienced its worst monthly performance in seven years, while in the U.S., the S&P 500 index dropped almost 7% and the Nasdaq, composed largely of tech stocks, plunged more than 9%.

While many analysts anticipated this situation, some investors were surprised by its suddenness after so many years of market growth. Here are five facts drawn from the history of stock market drops that can help us put this recent economic situation into perspective.

 

1.   Market drops occur frequently

A study by Deutsche Bank cited on the Motley Fool website reports that, on average, stock markets will register a correction – i.e., a drop of 10% or more from a recent peak – every 357 days. This works out to a market correction at least once a year. The duration of the drop may vary, but when it happens in a matter of days it will obviously attract more attention.

2.   Downturns generally do not last as long as upturns

Since the end of the 1920s, based on the U.S. market’s S&P 500 index, we have seen eight bear markets, i.e., drops of at least 20% from a recent peak. The average duration of these bear markets was 1.4 years. In comparison, the average duration of bull markets works out to a little more than 9 years.

2.   Patience is a virtue

It is true, however, that the markets can take varying lengths of time to make back their losses and return to pre-correction levels. As illustrated by the following graph, even though the stock market historically shows a strong tendency to rise, the wait can at times be a few months, a few years, or even many years, before it climbs back to a previous all-time high.

 

Graph representing the behaviour of the U.S. market’s S&P 500 index from 1950 to today. The graph shows strong growth for the period as a whole. However, it identifies 11 periods when the index dropped with respect to its previous peak and notes the time it took to return to that level. In seven cases, the index took about a year to recover its losses. In one case, in the early 1970s, it took three years. On two occasions, in the second half of the 1970s and after 2008, it took six years. Finally, it took eight years for the S&P 500 to recover from its drop in the early 2000s.


4.   A 10% drop is not recovered by a 10% rise

In this respect, it could be wise to remember that to recover from a loss, you need returns that are higher, percentage-wise, than the loss itself. For example, if you lose 50% of $100, you are left with $50: to regain your initial amount, you would have to earn another $50 on this $50, i.e., a return of 100%. More generally speaking, you would need a return of 5.26% to erase a loss of 5%, a return of 11.33% to erase a loss of 10% and a return of 33.33% to erase a loss of 25%.

5.   Historically, bulls tend to outrun bears

We can see that since the 1920s, bull markets seem to outweigh bear markets time after time. During this period, still taking the S&P 500 index as our benchmark, bear markets saddled investors with an average cumulative loss of 41%. On the other hand, the bull markets would have generated an average cumulative total return of no less than 480%.

It is important to remember that past performance is no guarantee of future results. However, these few historical facts can help to provide some perspective on the stock markets’ behaviour in October and, in a broader way, on market ups and downs in general. Many investors still remember the last stock market meltdown: the one 10 years ago, when prices dropped by about 50% over a period of fifteen months. Since then, up until this past September, the stock markets have provided what many analysts consider to be one of the longest bull markets in history at more than nine and a half years, with a cumulative return of 385%.

 

* Mutual funds are offered through mutual fund representatives associated with SFL Investments Financial Services Firm.

The following sources were used to prepare this article:

Four Pillar Freedom, “Here’s How Long the Stock Market has Historically Taken to Recover from Drops,”  June 21, 2018.
FT Porfolios, “History of U.S. Bear & Bull Markets Since 1926.”
Investopedia, “Stock Market May Plunge 25% as Yields Soar: Goldman Sachs,” February 28, 2018; “Stock Market Nears Longest Bull Run in History,” August 13, 2018.
Les affaires, “Bourse: les marchés terminent le mois d'octobre dans le calme,” October 31, 2018.
See it Market, “Limiting Losses: The Key To Long-Term Investing Success,” April 19, 2016.
The Motley Fool, “6 Things You Should Know About a Stock Market Correction.”