The Compound and Friends - Barry Ritholtz on the Psychology of Stock Market Corrections

Episode Date: April 29, 2019

Barry Ritholtz wonders why everyone is still so surprised every time the stock market has a correction. The psychology surrounding stock-market declines and recoveries is fascinating. Anytime markets retreat even a little bit, the noise surrounding the event begins to swell. Given how frequently markets jink and turn, you might expect people would be used to the occasional plunge by now. Full transcript of Barry's rap on the subject available here: https://ritholtz.com/2019/04/corrections-declines/ You can read more about Brendan’s take on behavioral coaching at his blog Your Brain on Stocks: https://yourbrainonstocks.com/i-need-behavioral-coaching-said-no-one-ever/ Enable our Alexa skill here - "Alexa, play the Compound show!" https://www.amazon.com/Ritholtz-Wealth-Management-LLC-Compound/dp/B07P777QBZ Talk to us about your portfolio or financial plan here: https://ritholtzwealth.com/ Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer if you seriously need this spelled out for you. https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

The psychology surrounding stock market declines and recoveries is fascinating. Anytime markets retreat, even a little bit, the noise surrounding the event begins to swell. Given how frequently markets jink and turn, you might expect people to be used to the occasional plunge by now. Alas, that is simply not the way human emotions and memory works. As of recently, the Standard & Core 500 was mere points away from an all-time high. This was set in September of 2018. Lest we forget, a 20% drop from those highs and a 25% move brought us very close to that peak. Neither the angst of the decline nor the bliss of the recovery are in any sense of the word rational. As we close in on that

prior mark, it might be helpful to consider some details on what pullbacks, corrections, and bear markets actually look like and why we as a species deal with them so poorly. Let's start with an important caveat. The terms we all use, drawdowns, corrections, pullbacks, retracements, recoveries, these are just made-up words without any formal definitions. These are just made up words without any formal definitions. Pundits and traders and media pretty much started using these terms because it was very helpful to try and explain things that were very hard to explain. The convention is that a 5% move down is a pullback, a 10% drop is a correction, and 20% is a bear market. These categories have no real meaning or statistical significance. Let's look at that 5%.

On average, markets fall 5% a couple of times each year. Most people barely register a decline of that size. Once we get to 10% declines, people begin to take a little bit of notice, despite the fact that they're relatively common. Data research tells us that in the post-war era, there have been 23 instances when the S&P 500 fell 10%, but less than 20%. So when we're looking at a 10% or more drop, but less than 20%, that occurs about once every three years. If you include all declines of more than 10%, meaning maybe it's 15%, maybe it's 20%, maybe it's 22%, but no limitation, 10% or more, we get about two of those every three years. Most of the falls that are 10% plus or minus tend to be short and shallow.

Once the decline runs its course from the short-term lows, markets typically take about four months to recover that drawdown. to recover that drawdown. This suggests that if the fourth quarter slump and recovery is quote-unquote normal, then sometime in April, the S&P 500 should regain that record high in the S&P 500 of about 2940. That was said in September 2018. You know, our institutional colleague Ben Carlson found that when stocks cross the 10% decline, when they cross that threshold, about half the time, they never get much beyond 15%. 60% of the time, according to Carlson, that 10% decline does not suggest a bear market is happening because in the future, it does not happen. But this means that 40% of the time we see a drop of 20% or worse. This probably is what explains the nervousness

amongst investors when we see a normal moderate 10% drop. Everybody fears losses far more than we like gains, so this risk aversion might account for this anxiety, the expectation that worse is yet to come. Something else seems to kick in when we see stocks drop from 15 or 20%. Maybe it's that residual post-traumatic stress disorder that's left over from the financial crisis. order that's left over from the financial crisis, hey, markets are cyclical. And so far, they've always recovered from what has proven to be temporary bear markets. But that doesn't make them any less unpleasant to deal with while they're happening. And my fellow scribes, they don't really help. They're very good at reminding readers that markets tend to anticipate recessions, even if markets have proven

not to be such great prognosticators. Our experiences with bear markets vary. Some are short and sharp. Others are, I'm sorry, some are short and sharp, and others are deeper and longer lasting. Historically, U.S. markets have always recovered, always recovered from bear markets. Historically, U.S. markets have always recovered from bear markets. However, markets can and do get cut in half on a regular basis. 1973-74, the Dow Industrials fell 57%. During the dot-com implosion, the Nasdaq index took an 88% swan dive from its peak in March 2000. The most recent financial crisis saw the S&P 500 fall about 57%. Yes, there are troubling exceptions,

and maybe this helps to explain why everybody is so worried. For example, the Japan Nikkei 225 stock average hit its high 30 years ago in 1989. Today, it's 44% below that peak. And then reconsider the Dow from 1929. It took 25 years to regain that peak all the way up to 1954 on a price basis. It got there a little faster if we include dividends. So the annoying trope that gets used at times like the fourth quarter is that the U.S. markets are turning Japanese and a long and maybe endless doldrum awaits us. This preface never seems to account for the fact that in 1989, the P.E. ratio of the Japanese Nikkei Dow was 60 times the trailing 12-month earnings.

60 times. That's triple the valuation of the S&P 500 today. So no, the U.S. market isn't turning Japanese, and the probability for that outlook is dim, and markets are probably going to continue along their bullish path. They have shown they recover in due time here in the United States. Eventually, we'll figure out our trade and budget issues. Maybe we'll even get past this current moment of political discord.

That's the better and more rational reason to bet on U.S. markets. I'm Barry Ritholtz. Thanks for listening. If you want to learn more about our views on markets and the economy and investing, be sure and check out The Compound every day.