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