What The Data Says About Market Crashes


When we travel by air, my wife usually points out that she thinks it would be better if people by windows boarded first; that way, anyone in an aisle or middle seat wouldn’t have to keep standing up. Meanwhile, I think the Southwest Airlines style of pick-any-open-seat is optimal.

Our “gut feelings” were recently rendered irrelevant when we ran across an old episode of “MythBusters.” In it, the cast built a mock 173-seat aircraft and tested several boarding approaches using real people and luggage.

Relying on the data cut through the emotional biases. It also inspired me to take a similar data-backed look at a common question I hear about systematic investing: Is this style of investing capable of reacting fast enough to declining markets?

To dig into that question, I think it’s helpful to first acknowledge that not every market decline is the same.

Price Shocks vs. Sustained Declines

I think it’s important to distinguish between the two distinct forms of market declines: sustained declines in value and temporary price shocks.

Sustained declines can take several months or years to develop before reaching an eventual trough. The more common vernacular is “bear market,” and the importance of protecting capital during these times is well-understood.

On the other hand, a shock is a rapid decrease in the price of an asset, usually over a few days or, at most, a few weeks. To understand if it’s as important to protect against these declines, I looked at the S&P 500 Index since 1950 and extracted data about the 20 worst weeks.

Exhibit A: Worst 20 Weeks for the S&P 500 (January 1950 to June 2022)

Return for the Week

Week Ended On

Preceding Drawdown

-18.20%

10/10/2008

-29.77%

-12.20%

10/23/1987

-16.06%

-11.98%

3/16/2020

-18.89%

-11.60%

9/21/2001

-28.47%

-10.54%

4/14/2000

-0.73%

-9.51%

3/12/2020

-10.70%

-9.40%

10/3/2008

-22.48%

-9.12%

10/16/1987

-7.63%

-8.71%

9/13/1974

-40.60%

-8.39%

11/21/2008

-44.20%

-7.99%

7/19/2002

-39.68%

-7.91%

9/12/1986

-1.32%

-7.60%

3/9/2020

-8.74%

-7.58%

6/30/1950

-1.34%

-7.41%

9/27/1974

-41.67%

-7.19%

8/5/2011

-17.43%

-7.09%

12/6/1974

-41.81%

-7.03%

3/6/2009

-53.03%

-7.00%

10/13/1989

0.00%

-6.87%

2/20/2009

-46.64%

Source: Global Financial Data, Commodity Systems Inc., and Blueprint Investment Partners, 1/3/1950 to 6/30/2022

Interestingly, price shocks were most likely to occur during one of the following:

  1. A steady bull market
  2. Deep within an entrenched bear market

You see in the data that 14 of the shocks, or 70%, occurred when the preceding drawdown (the percentage decline from the previous all-time peak to subsequent trough) was less than 2% or greater than 20%. In fact, seven of the 20 worst weeks (35% of the samples) occurred after the index declined approximately 40% or more from its recent peak.

Sustained Declines, Not Shocks, Are the Enemy of Compounding

Since so many price shocks took place when the market seemed to already be in decline, I examined this point further by reviewing the characteristics and timing of all drawdowns in the S&P 500 greater than 20% during the same time period.

Surprisingly (at least to me), the S&P experienced only 11 unique drawdowns of 20% or more during the past 70+ years. (I defined unique as a 20% or greater decline from the previous peak to the next high. Multiple recoveries that did not result in a new high before declining back below 20% only counted as one drawdown, and the date noted is for the first time there was a decline below 20%.)

Although only seven of the 11 cases are associated with a recession as defined by the National Bureau of Economic Research, nine took more than 100 trading days to develop.

Exhibit B: Characteristics of 20% or Greater Declines (January 1950 to June 2022)

Days to Reach -20% or Greater

Date -20% or Greater Was Reached for the First Time

Days to Recover

Recession?

310

2/22/1982

178

Yes

305

10/21/1957

234

Yes

288

1/29/1970

532

Yes

242

3/12/2001

1,561

Yes

221

11/27/1973

1,677

Yes

188

7/9/2008

1,188

Yes

139

8/29/1966

171

No

115

5/28/1962

319

No

111

6/13/2022

18

Too soon to know

38

10/19/1987

447

No

16

3/12/2020

110

Yes

Source: Global Financial Data, Commodity Systems Inc., and Blueprint Investment Partners, 1/3/1950 to 6/30/2020

When you marry the information from both exhibits, you realize that eight of the top 10 price shocks hit in the time between when the S&P 500 developed a greater than 20% decline and when it subsequently recovered. For example, the -11.60% shock of September 2001 arrived months after the S&P 500 had already declined more than 20% (March 12, 2001) and long before the index finished its 1,561-day recovery.

To me, this data signals two important points:

  1. Most bear markets don’t begin with a price shock.

  2. Since most significant shocks happen during prolonged declines, asset managers and financial advisors should be more concerned with protecting against sustained market declines than managing the risk of each individual price shock.

The second point is one of those making sure to see the forest, not just the trees, things.
Historically, sustained declines happen slowly and without fanfare. They usually can be categorized into three phases, last longer than most people expect, and have a prolonged recovery. Consider the recovery times of 2001, 1973, and 2008 in Exhibit B. That’s an average of almost 1,500 trading days to recover.

The price shocks that occurred in the latter stages of these three bear markets were not the best time to implement downside protection measures. Instead, downside protection would have been more meaningful if applied months earlier, as the market began its slow decline.

How Would Systematic Investing React?

With that background in mind, now comes the fun part: testing the question of whether systematic investing can react fast enough to declining markets.

Since the data thus far has established value in focusing on protecting against prolonged declines over arbitrary price shocks, I created an illustration that applied two trend-following methodologies to the time periods in Exhibit B:

  1. Long-term system: If the 50-day exponential moving average (EMA) was above the 200-day EMA, this represented an “uptrend,” and the signal would be to buy or hold. If it was below, it meant a “downtrend,” and the signal would be to sell.

  2. Intermediate-term system: If the 10-day EMA was above the 100-day EMA, the signal would be to buy or hold. If it was below, the signal would be to sell.

Here are the signals presented by each trend-following system during the time periods from Exhibit B:

Exhibit C: Trend Signals During 20% or Greater Drawdowns (January 1950 to June 2022)

Date of -20% or Greater

Long-Term Trend-Following System Signal

Intermediate-Term Trend-Following System Signal

2/22/1982

Sell

Sell

10/21/1957

Sell

Sell

1/29/1970

Sell

Sell

3/12/2001

Sell

Sell

11/27/1973

Sell

Sell

7/9/2008

Sell

Sell

8/29/1966

Sell

Sell

5/28/1962

Sell

Sell

6/13/2022

Sell

Sell

10/19/1987

Hold

Sell

3/12/2020

Hold

Sell

 

Now let’s bring everything together:

  1. Sharp declines are rarely a leading indicator of future poor performance. Only the weekly declines from 1987 and the 2020 Coronacrash led to a 20%+ drawdown.

  2. Systematic investing signals flashed “sell” for most severe sustained market declines since 1950. In each of case (sans 1987 and 2020), both trend-following signals would have resulted in exiting the market prior to it hitting a 20% drawdown.

What the exhibits appear to present thus far, is that systematic investing can react fast enough to declining market environments, assuming your primary goal is to protect long-term compounding.

Optimizing Timeframe Selection

At Blueprint Investment Partners, we seek to provide financial advisors with strategies that help protect against market environments that are likely to cause an end client to miss his or her long-term financial goal. If we can dissect the markets to understand where the most problematic risks exist, that provides an advantage to us and our clients.

As risk managers, it is also critical that we understand the types of markets in which we can expect to excel and those where we might lag. Doing so allows us to communicate with advisors so they can pass that knowledge on to their clients.

As it relates to temporary price shocks and sustained declines:

  1. During sustained market declines, our process will usually meaningfully reduce exposure
  2. During price shocks, our process may reduce exposure just before a rebound

Periods like the second scenario inevitably occur and highlight the tradeoffs associated with selecting timeframes for a systematic investing process:

  • Use a short-duration timeframe that is informed by only a few days of price data, and you might experience some benefits by more frequently missing individual price shocks, but it may create short-term capital gains and noisy statements (higher turnover and transaction costs)
  • Use a very long-duration timeframe, and you may experience a better tax profile but find you don’t get out of declining markets fast enough or, on the flip side, don’t get back in soon enough when markets recover or rally

Blueprint portfolios are constructed with a blend of three timeframes that attempt to maximize tax efficiency while avoiding conditions where price shocks matter most: large drawdowns:

  • Intermediate-term: Uses 10- and 100-day EMAs
  • Long-term: Uses 50- and 200-day EMAs
  • Strategic: A portion of the portfolio is bought-and-held

We believe these timeframes help us ignore price shocks when they are market noise, while reacting in advance to shocks that are part of a longer-term market decline.

I hope the data in this blog has helped cut through any emotional biases you may have about market declines, just as “MythBusters” helped settle my wife and my lighthearted dispute. If you’d like to learn more about Blueprint’s process and approach to risk management, please reach out.


 

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Past performance is not indicative of future results. The material above has been provided for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.

Information obtained from third-party sources is believed to be reliable though its accuracy is not guaranteed.

Information contained on third party websites that Blueprint may link to are not reviewed in their entirety for accuracy and Blueprint assumes no liability for the information contained on these websites.

Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice.

An index is an unmanaged portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.

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The long-term system applies a trend-following investment strategy to the S&P 500 TR Index. If the 50-day exponential moving average (EMA) was above the 200-day EMA, this represented an “uptrend,” and the signal would be to buy or hold. If it was below, it meant a “downtrend,” and the signal would be to sell.

The intermediate-term system applies a trend-following investment strategy to the S&P 500 TR Index. If the 10-day EMA was above the 100-day EMA, the signal would be to buy or hold. If it was below, the signal would be to sell.

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