The Silver Lining Of Stock Market Crashes

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Includes: DIA, SPY
by: The Virtuous Cycle

Summary

It’s been said before but it bears repeating: future returns are superior when stock valuations are most favorable.

The market reaching an all-time high can be an exciting occurrence, but it also exposes investors to greater risks.

Although seemingly counterintuitive, a stock market crash can be a more favorable event than the market reaching a new all-time high.

There’s a silver lining to bear markets which can be difficult to recognize without proper perspective or experience.

What is it like to live through a bear market and what should an investor expect the subsequent results to be?

"Prolonged high stock prices are manifestly a great misfortune" - William Bernstein, The Four Pillars of Investing.

Cheering for Dow 21,000? What for?

January marked the first foray for the Dow Jones Industrial Average (NYSEARCA:DIA) above the 20,000 level and was the second-fastest advance from 1,000-point threshold to the next in the history of the index. Now, as the Dow marches toward 21,000, should we join the celebration?

While, like most investors, I prefer stocks to gain in value after purchase, I'm also cognizant that movement to higher levels indicates that more of the gains are found by looking in the rear-view mirror rather than at the road ahead.

The more disconnected the market becomes from its underlying fundamentals, the greater investors' exposure to long positions in equities. The price-earnings multiple on the S&P 500 Index currently stands at 24.8. What's one recent instance of the S&P 500 reaching a similar P/E multiple range? June 2008 at 24.9 and September 2008 at 25.4. Everyone knows what happened next during the financial crisis that followed.

While predicting a similar event is notoriously difficult, it's important to be aware of potential risks of investing in equities at elevated levels. And if such an economic shock occurs or if another event chases capital into alternative investments, the current premium valuation of the broad market index doesn't leave much downside protection. Although stock market crashes can be a major shock to the financial system and to an investor's psyche, the impact can be minimized by preparing in advance. That entails knowing what it's like to live through a bear market and what to expect after the fact.

The History of Stock Market Crashes: One Example

So, what might such a market crash look like and how would it affect us as investors? Let's view this through the lens of history before we finish off with the upshot by explaining the eventual outcome of bear markets and crashes.

We'll examine the 1970s bear market for this particular example. In Against the Gods: The Remarkable Story of Risk, Peter Bernstein aptly describes the attitude of the high-flying era of the Nifty Fifty which preceded the 1970s bear market:

Investment managers defined risk in the Nifty-Fifty, not as the risk of overpaying, but as the risk of not owning them: the growth prospects seemed so certain that the future level of earnings and dividends would, in God's good time, always justify whatever price they paid.

The era was characterized by the decisions of investors to throw money at the premier blue chip companies of the day, bidding up McDonald's (NYSE:MCD), Disney (NYSE:DIS), Coca-Cola (NYSE:KO), and others to earnings multiples ranging from 70 to 95 during the boom times.

It couldn't last. Ultimately, the Dow Jones Industrial Average collapsed from its all-time high in January 1973. The oil crisis and Watergate scandal that followed gave rise to a punishing bear market which sent stocks into a 45% decline.

William Bernstein reports on this era in the Four Pillars of Investing. He notes that McDonald's valuation declined from a P/E of 83 in 1972 to just 9 in 1980. Polaroid dropped from a 90 P/E to just 16. Other high-promise growth stocks suffered the same fate. Investors who targeted high-quality blue chips in favor of their riskier cyclical counterparts found that there was still plenty of risk to be found in the underlying valuations of the stocks they selected.

While large and rapid losses are painful to stomach in the short term, the more damaging and enduring effects of bear markets and stock crashes may be the indelible memories they leave on those who experience them. While any one bear market or crash has always been a recoverable event, such a recovery can only be achieved by investors whose attitudes and decisions aren't distorted by the confusion and panic of the times they live in.

What It's Like to Live Through a Bear Market

So, what is it like to live through a bear market? It's been long enough since the last one that some memories undoubtedly are starting to become foggy. Luckily, a 2009 article in the Wall Street Journal describes lucidly the experience of living through such an event. One professional investor echoed what we just saw above, that any stocks bought during the era "turned to dust." Another broker recalled how making calls to prospects was "brutal." "If somebody would even take your call you'd be delighted." Another practitioner was quoted as saying that, "The summer of 1974 was so bad that we used to go out to the bars at lunch and not go back to the office."

If this time frame was so challenging for investment professionals, the reason is because their clients had largely abandoned them, taking their own minds off the unpleasant thought of investing in a bear market and perhaps avoiding stocks altogether until conditions improved. So, what was the behavior of the average investing household during this bear market?

Bernstein discusses a Businessweek article from 1979 titled "The Death of Equities." It alludes to the flight of capital from stocks to other investments, with the percentage of households owning stocks being halved from 30% to 15% since the 1960s. The situation draws attention to the likelihood of common investors to follow the crowd, completely ignoring more sound advice, while buying in before a drop and selling out before the eventual rebound. Although such behaviors are clearly not in an investor's best interests, they can be hard to avoid. But what type of mindset is necessary to sidestep these types of errors?

What Are Some More Productive Ways to Respond to a Bear Market?

Interestingly, we've seen the enthusiasm of investors, even professional money managers, during boom times when they're willing to bid up prices of top stocks to unrealistically large valuations. Following that, we've seen that clients become so discouraged during bear markets so as to not even pick up the phone and take a call from an advisor. But do these extreme reactions to the opposite spectrums of market phenomena square with reality?

Let's consider the attitude of some legendary investors towards bear markets. Take Peter Lynch. He writes that "a decline in stocks is...as normal as frigid air in Minnesota." Lynch draws a parallel between a stockpicker's approach to a market drop and a Minnesotan's expectation for cold winter weather:

You know it's coming, and you're ready to ride it out, and when your favorite stocks go down with the rest, you jump at the chance to buy more.

Lynch's attitude is quite different from the ghost town investing mentality of the 1970s market that we just examined, and also a part of what made him one of the most successful investors of all time.

Likewise, Warren Buffett says that, "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is." Here, Buffett is stating that danger lurks in a rising market, particularly one characterized by unbridled enthusiasm. Instead, investors may fare better by going against the grain and the conventional wisdom currently prevailing.

What's more is that William Bernstein goes as far as to say that a young person should get on their "knees and pray for a stock market crash." Why so? Because, he says:

For the young investor, prolonged high stock prices are manifestly a great misfortune, as he will be buying high for many years to invest for retirement.

So, while harsh and painful to endure, there's truly a silver lining to bear markets that can be difficult to recognize without proper perspective or experience. We've seen the demoralizing nature of major bear markets and the despondent greeting investors have given them, but in contrast, we have also seen a different perspective from highly successful investors who welcome such events and stay the course. Why the dichotomy between the two, and what's the upshot that we should glean from these differing reactions?

The Silver Lining of Crashes and Bear Markets

Let's take it from William Bernstein:

The rewards for fishing in such troubled waters are staggering. For the 20 years following the 1932 bottom, the market returned 15.4% annually, and for the 20 years following the 1974 bottom, 15.1% annually.

As can be seen, investing during times of trouble has historically led to great rewards. How might that contrast to the returns we can expect from today's levels? Bernstein and Burton Malkiel offer a method of forecasting future stock returns that's beautifully simple as it is intuitive and easy to understand. If we hold valuations constant, the two sources of investment returns are (1) earnings growth and (2) dividend yield. Both authors cite 5% as the approximate long-term growth rate of corporate earnings in the U.S. Apply the 5% growth rate to the currently prevailing 2% dividend yield, and future returns would add up to 7% per year, assuming no change in valuations.

However, valuations do change. So, let's consider what effect fluctuations in the market value of equities might have on our forecasted 7% return. We'll shorten our time frame from 20 years to 10 years for this forecast and assume corporate earnings growth could range anywhere from -2% to +7% annually. Terminal price-earnings on the S&P 500 (NYSEARCA:SPY) will range from 8 to 24 for our set of assumptions.

In the chart below, I summarize what the future might hold for the next 10 years of equity returns under each scenario:

Projected 10-Year Annualized Return of the S&P 500

Simply maintaining the same 24 P/E ratio and 5% historical growth rate would produce a 7% return. But at a 5% earnings growth rate and repricing of the market valuation to a more modest 16 times earnings, future returns, including dividend yield, would be just 2% over the next 10 years. Reaching a 9% annualized return would require a 7% earnings growth rate and terminal P/E of 24, both of which are seemingly optimistic goals. The chart also shows that it's certainly feasible to envision a decade of zero returns, such as would be the case under 4% earnings growth and 14 earnings multiple.

In fact, to forecast the premium equity returns that investors have come to expect, one must predict earnings growth and valuations multiples that are generally unheard of historically. While equities could still go on to produce a satisfactory return from today's levels, the likelihood is that such returns will pale in comparison to the longer-term averages.

But there's an important caveat to be considered. And that caveat is the effect that a stock market crash could have on future expected returns. To make this alternative forecast, we'll rely again on an example from William Bernstein in The Four Pillars of Investing.

If future market returns are a function of earnings growth and beginning dividend yield, then the current yield of the market is a vital factor in forecasting long-term returns. At a beginning dividend yield currently at 2% and assuming 5% earnings growth, we could expect long-term returns of 7%.

But if the market crashed 50%, valuations would be cut in half and the dividend yield would double to 4%. If we still assume a 5% earnings growth rate, total annual return would reach 9%. And at an 80% crash, the dividend yield would increase five-fold to 10% and produce a 15% future return after adding in earnings growth. The table below displays each of these assumptions.

Estimated Market Return Under Various Scenarios

No Change 50% Decline 80% Decline
Dividend (Earnings) Growth Rate 5% 5% 5%
Dividend Yield 2% 4% 10%
Total Return 7% 9% 15%

Source: Table borrowed from the Four Pillars of Investing by William Bernstein

A modest individual contributing 5% of a $36,000 salary to a retirement plan would see the following accumulations after 30 years under each scenario:

30 Year Accumulation Under Various Scenarios

No Change 50% Decline 80% Decline
Annualized Return 7% 9% 15%
Subsequent 30 Year Return $183,000 $275,000 $1,038,000

The silver lining of stock market crashes is that future returns have always been much greater when rebounding off of bargain price levels. As can be seen from the analysis above, a resilient investor who maintains rather than curtails his investment program during a bear market or crash stands to earn far greater returns in the long run. Long-term prospects under our current market conditions are much less favorable when viewed with the appropriate perspective. It follows that cheering for such milestones as Dow 20,000 or Dow 21,000 are irrational responses by investors, because ever-increasing stock prices in the near term do us few favors if we've adopted a long-term time horizon.

Concluding Thoughts

Other studies back up the relationship between current yield and future returns. Burton Malkiel discusses research from Eugene Fama and Kenneth French, as well as Robert Shiller. Their findings are that since 1926 beginning yields ranging from 3.7% to above 6% produce subsequent 10-year annual returns of 11.5% to 16%. By contrast, yields of 2.2% and below, which is where the market stands today, produce subsequent 10-year annualized returns of 4%.

If history is any guide, future long-term equity returns will not be as robust from today's levels as they have been in past years. Still, other research has shown that investors who attempt to time the market and sidestep corrections and crashes, generally, are employing a losing strategy. Alternatively, there are several more healthier mindsets and approaches which investors may choose to adopt. A few examples:

  1. Nothing Bad Ever Happens in the Stock Market - Whether the market goes higher, lower, or sideways, investors will win regardless.
  2. It's a stockpicker's paradise. If the broad market indexes are likely to produce mediocre returns from their current levels, stock selection will be key to achieving superior results. Pockets of value can still be found even if the market as a whole is richly valued.
  3. Steer clear of high risk securities, even those offered by very promising businesses if they already have several years of future growth priced in. Instead, it may be prudent to wait for a better entry point and focus on other opportunities in the meantime.
  4. Stay the course. The current market conditions will not always prevail. A fair amount of bubbles and bursts can be expected during an investor's lifetime. Be consistent, keep the proper perspective, and know that higher risks today could give way to greater opportunities tomorrow. Be prepared to recognize them when they arrive.

What's your approach to investing in today's environment? Share your thoughts below.

Author's Note: Investors who valued this analysis and wish to receive future articles and ideas from The Virtuous Cycle can do so by clicking the "Follow" button at the top of the article and selecting real-time alerts.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All investments involve risks. This article is only general analysis, and is neither financial or investment advice nor a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals are encouraged to do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.