Managing Expectations During Steep Stock Market Drawdowns

A bull market can be a fragile thing. To paraphrase Hemingway, there are two ways that investing profits can turn into losses: gradually, then suddenly.

The latter profile applies to the latest adjustment in the S&P 500’s current drawdown. As recently as early October, the US stock market’s drawdown was measured in a few basis points. By the close of trading on Christmas eve, the S&P’s peak-to-trough decline crashed to just a hair under -20%.

The market’s reversal of fortunes appears to signal that a new bear market has arrived and so it’s time once again to revive and renew the skill-set that invariably withers in bull markets – especially those of the long-running variety, such as the one that may have just died. By some accounts, the late, great bull was the longest since World War II.

As for the future, the recent market volatility can play havoc on our ability to think clearly on matters of rebalancing, portfolio design and updating expectations on risk and return. How, then, should we manage our outlook for equities? The true answer is multi-dimensional, covering an array of metrics and processes. We can start, however, by reviewing the S&P’s one-year trend through history relative to drawdowns, if only as a baseline for deeper analytics.

As a simple example, the chart below compares the S&P’s 1-year performance following the drawdown from a year earlier. For example, the drawdown for Oct. 1, 1960 (x axis) is compared with the trailing 1-year return through Oct. 1, 1961. A key takeaway in the chart: the relationship between current drawdown and the 1-year return a year down the road tends to be noise – until the drawdown approaches -40% and deeper. (Note: 1-year returns are defined using a 252-trading-day cycle.)

Once drawdowns reach -40% (and beyond), history shows that the 1-year performance of the S&P a year later is always positive, based on the track record over the past six decades. By contrast, the current drawdown (-19.8%), shown by the blue line, is just as likely to lead to a gain as it is a loss a year from now. (Technically, there’s a slight bias for positive one-year return at the current drawdown, but practically speaking the average investor isn’t likely to perceive that distinction.)

None of this matters, of course, if your time horizon is substantially longer than a year. A 20% drop in the market from the previous peak (which implies a 20% rise in expected return over the long haul) looks considerably more attractive if you’re running a strategy that can sit tight for a decade or more.

By contrast, a 20% drawdown may disappoint if you’re expecting a rebound gift by next Christmas. But if the pain continues, the odds rise sharply that a solid rebound is high-probability event in the short term. Nice, but that’s still no free lunch. When (or if) the current drawdown sinks to -40% or more, your appetite will be low, perhaps nonexistent, for giving Mr. Market fresh capital to deploy. Such is the paradox of markets and behavioral risk: When the trailing performance is deep in the red, implying that the outlook is dark, the ex ante return surges. By that point, there will only be a relatively small number of investors still capable (mentally and/or financially) of accepting Mr. Market’s generous terms.

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By James Picerno

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