The anatomy of market corrections — Covid-19 (Part II)

"Invest for the long haul. Don't get too greedy and don't get too scared."
— Shelby M.C. Davis

Fast & Furious #23

The current correction in markets is fast and furious like the movie (Fast & Furious 9, the movie, is being filmed now and will be released this year). The unfolding drama of this market correction is the 23rd instalment since the global financial crisis that bottomed in 2009 (counting corrections of 5% or more).

Currently, the media is making a big deal out of this correction as it has taken just one week to fall more than 10% and it is the fastest 10% correction we have seen since 2008. Ironically, for the S&P 500, the two fastest corrections happen to be the two most recent ones - 2018 and again in 2020.

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The speed at which this correction occurred has taken many by surprise, but it also means very few people were positioned well for it and chasing the market down has never been a great strategy for individual or professional investors alike.

Timing the market to predict the top or bottom of markets is always a losing proposition.

That's the speed of the correction, but what about the magnitude?

So far — Endowus is not in the business of forecasting; we do not know whether there is more downside to come or if we will see a rebound — looking at the benchmark for developed markets, the MSCI World Index calculated in Singapore dollars, it is now down 12% from its peak just 12 days.

This already ranks #7 in magnitude out of those 23 corrections. Most major global indices are down double digits: S&P 500 is -12.8%, MSCI ACWI is -11.8% and MSCI Emerging Markets -12.3%.

Read more: Are epidemics and pandemics good for financial markets? (part 1)

We have been talking about the extended length of this economic expansion and the market performance during this period for a while now. Since we hit the cyclical bottom in March 2009, we have had a good run in equities with the World Index up 254% and the US S&P 500 up 401% at the recent peak.

However, the rally was not without its fair share of bumps, some quite large, along the way. Also, the rallies have rarely been fast or furious, but more slow and steady just the like underlying economic recovery, which is on an extended period of growth but is one of the slowest and shallowest in history. We have yet to see the parabolic moves of 1999 or 2007.

The anatomy of corrections

As mentioned, in total we have had 23 corrections with a magnitude of more than 5% and we have also had 7 major corrections of more than 10%. Furthermore, unlike some narrower market indices and those in the US which have yet to see a 20%+ correction, the World Index in SGD has already experienced 2 of more than 20%. However, each time, the market shook it off and continued to move to new highs.

The average of those 23 corrections was a fall of 9.8% over approximately 2 months. The 7 corrections of more than 10% saw a fall of 16.6% over an average period of around 5 months. Deeper corrections obviously lasted longer.

If we look through an extended period in history, the numbers are not that different. The anatomy of corrections thus can be summarised as follows;

1. There is normally one major correction of over 10% each year.
2. The average magnitude of a fall of around 10%.
3. The length of a correction is around 2.5 months
4. There are several smaller corrections every year.
5. We have had 7 corrections of 10% or more since 2008.
6. Historically, around 1 in 10 of these corrections continue into a 20%+ fall.
7. We have had 12 bear markets in around 67 years (as far as good indexes go back) with a quarter of them in the 1970s.
   

"The four most dangerous words in investing are: 'This time it's different.'"
— Sir John Templeton

Knowing what we know and what we don't know

The macro dynamics

There are only two other times where we had a similar fast & furious correction — in August 2011 and August 2015.

In 2011, we were in the throes of the Euro debt crisis and the downgrade of the US credit rating and concerns about an economic slowdown. In 2015 it was the end of QE, Greek debt default and the crash in China leading to a devaluation of the yuan. This year (2020), it is the ongoing Covid-19 epidemic and its impact on global growth.

We have to admit that severe economic and financial market dislocations are a real possibility, but the scale of the impact will ultimately depend on how this situation evolves from here.

Some will say the sharp correction already prices in these circumstances and risk, while others will say it has not. It is literally impossible to know the future and how this plays out.

As we wrote last week, if you hear of economists and market commentators making bold predictions, these should confidently be ignored. There is nobody who knows how things will pan out. So then, what do we know?

"The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what's going to happen contradicts my way of looking at the market."
— George Soros

First, we know that how the epidemic evolves from here will be important.

Does it remain a relatively small outbreak (in terms of % of the total population) with a low death rate, which is contained largely in Asia?

Or does it become a global pandemic as it spreads to key areas like the US, Europe, and Africa where we are starting to see some unconnected cases of Covid-19 patients?

Second, the impact on underlying economic activity will need to be gauged, which depends on the evolution of the outbreak.

Three things about the economic impact: there is a time element (fast) to it, as well as a quantitative element (furious). There are demand-side and supply-side elements.

There is finally a first-order impact, which is immediate and second or higher-order impacts to this that last longer to play out. Let me explain.

The demand-side impact comes from reduced activity — people stay home, eat out less, spend less, drive less, travel less, and so there is a demand-side shock.

But if this virus suddenly disappears tomorrow, we can safely assume that demand will quickly bounce back and recover to normal levels. Thus the demand side is often considered to be short-term, fast, and immediate. Of course, there are second-order impacts, such as some demand that would have been permanently lost — people are not going to eat five meals out because they stayed home and cooked more. Likewise, we may see some spending that compensates for lost time, too.

The supply-side, by nature, takes time as it takes longer to produce something than to buy something. As people stay home and are less productive, as factories close and production goes down, and as inventories are depleted, we are likely to have some permanent loss of economic activity.

While lower demand may bring certain products and services to equilibrium, in general, we can say that the impact on the supply chain takes longer and lasts longer too. Even if there is a sharp rebound in demand, we may see some supply not being able to keep up. We only need one key component in auto parts to be missing to stop the car from being manufactured, for example. These disruptions could potentially result in any recovery taking longer than expected.

Third, we can look at the financial markets and the underlying conditions prior to the corrections.

Many people argue that during SARS, the market was barely recovering after the dot.com bubble bursting and markets had only just established a bottom. While the current state is that markets are at historical highs after a long period of recovery, albeit slow. People have been worried about a correction, valuations, and looking for an excuse to sell rather than buy.

However, the other side of the argument goes that we already had a major correction of 20% or more in 2018, which ended barely over a year ago. Every other asset class, whether it be bonds, real estate, private equity or private venture companies, are all at more expensive levels.

There is also a lot of money sitting on the side that missed the rally or wants to come back in or is waiting to be put to work. As the aphorism goes, nobody wants to catch a falling knife — that is true. But it is true that liquidity is abundant and the Fed is likely to cut rates further to protect demand and the economic expansion.

This leads to the final factor that we must consider, which is the intent and ability of governments and central banks to use policy as a tool to protect the underlying economy and hence the financial markets.

Just look at China. While we are sceptical in general of government and public policy interventions in markets being sustainably beneficial, in the short-term fiscal stimulus or support could buoy demand in the economy especially when there is an external shock, and the monetary stimulus is something that clearly does benefit financial markets over the medium term.

The anatomy of a recovery

As individual investors, who are investing for the long-term and largely rely on a regular savings plan to build up our wealth and participate in markets, there is one thing that is going in our favour for us historically. It is the fact that over time, the markets are positively skewed to move higher.

There is thus an asymmetry between the downside risk and the upside risk. The missed opportunity of not being invested during a rebound is huge. While the corrections or bear markets if we do not succumb to the pressure of selling on the way down, can be overcome through time. We talked about the anatomy of corrections, but we end this piece with two simple charts that show the anatomy of market recoveries when the correction is over.

This is probably the most important thing to realise — that there will be a bottom in markets when the correction is over, and the markets invariably will recover. This is something that we must always keep in mind.

The durations varied, but on average the correction, barring a major bear market, lasted two to four months, and it took a similar or shorter period to recover the previous high.

If we look at the 23 occasions of 5%+ corrections since 2008, after hitting bottom, on average the markets are up 15% after 12 months and 59% after five years as the above chart shows.

Yes, of course, there is a dispersion of returns and no two recoveries are the same. But we mapped out all 23 corrections and how the market did up to 60 months post the correction ending. We can clearly see the upward sloping chart with returns on average showing between 36% and 82% during that period.

Once again, we cannot predict how the viral epidemic and the economic playbook will play out.

What we do know is when this is over, the above chart is an indication of what is likely to happen to markets in recovery.

Instead of trying to time that bottom, we suggest you stick to your investment plan with a risk appetite that you are comfortable stomaching in the near term, and continue to put your savings into the markets regularly, so that when we are recovering you are still invested in the markets to enjoy the rebound.

It is normally a question of when, not if — no matter how fast or furious the correction has been.

Other articles on market timing:

• Raja Ampat and the rewards of time rather than timing
• "Hindsight is 20/20": Why we should stick to consistent, global diversification
• "I'll invest when the market crashes" is flawed. It's about time in the markets rather than market timing
• Be still, my beating heart: Time in the market rather than timing the market

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