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How Much Will Markets Decline: 10%, 25%, Or 50%? - Weekly Blog # 610

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Mike Lipper, CFA
Summary

One can divide stock markets falls into three categories: correction, secular, and fundamental.

A market correction is often not tied to an economic contraction.

Less frequent declines occur when upward earnings and economic trends are temporarily interrupted.

The largest decline by far is caused by fundamental changes in the structure of society.

The next unknown is no longer a question, securities markets will decline. Some are now focusing on signs that most securities markets are showing an increased potential for decline. I therefore turn to an even more difficult question of how big the decline will be. Based on history, the size and length of the decline will likely set up the size and duration of the following bull market.

Size And Duration Of Slump Influences Recovery+ Subsequent Growth

One can divide stock markets falls into three categories: correction, secular, and fundamental. Each are different because their causes and impacts are different. One of the most difficult tasks for professional investors is to prepare for a decline before it happens. Most investors firmly believe that a current trend is their friend and choose not to prepare. They believe that predicting a decline is impossible. Furthermore, they believe that they will see early evidence of a decline and will be able to exit with relatively small losses from peak prices. The truth in markets and sports is that all trends eventually stop, often abruptly. What is particularly costly is the belief that the current decline is only temporary and not a cause for action.

With those thoughts in mind, I'll examine the most frequently occurring, and in many cases the most painful type of correction. Enthusiastic investors are the major cause of market corrections. They ride an upward trend of expanding price valuations that get way ahead of fundamentals. For example, many stocks have recently gained over 20%, even though earnings were likely to be down in the fourth quarter. They are also likely to be down in the first quarter of the new year, contributing to the mid single-digit gains expected for 2020.

A market correction is often not tied to an economic contraction. Paul Samuelson, the great MIT economist, is quoted as saying "The stock market has predicted nine of the past five recessions." Typical market corrections are of the 10% magnitude and only last a couple of months. In the history of market analysis, often called technical analysis, the fall is due to "weak holders selling to strong holders at discounts." The painful part of the process is not the relatively small losses sustained by the weak holders, it's the much larger opportunity loss of missing out on the recovery and subsequent growth thereafter.

Less frequent declines occur when upward earnings and economic trends are temporarily interrupted. If the pause is caused by a specific event not expected to be repeated, long-term investors will stay committed. The problem is that what was first believed to be temporary often stretches out over time. If corporations and other investors begin to believe that a major change has occurred and their expectations of future cash earnings from their investments decline, it may cause a change in investment policy.

As many secular trends will reassert themselves, the pause should be tolerated without investors being shaken out of their positions. Demographics, education, and health are likely to be such trends. Secular changes usually happen slowly but can be recognized after a few years. There are often a couple secular changes within a decade that are capable of taking the large-caps that dominate the popular averages down about 25% from their peak levels.

The largest decline by far is caused by fundamental changes in the structure of society. A good example of this was the Great Depression, which has some parallels with conditions today. In the 1920s the WWI peace dividend freed up capital markets, encouraging both individuals and corporations to take on substantial debt. This led the politically sensitive farm community to increase production with borrowed money. Additionally, public utilities evolved into highly leveraged holding companies and Wall Street brokers enticed new investors to jump into "The Radio Boom". Each of these inputs, and others, were eventually dealt with by unwise federal government actions.

Against his own instincts, President Herbert Hoover signed a material increase in tariffs designed in part to help and protect farmers. It however also led to a major drop in world trade, particularly for labor-intensive manufactured products. One of FDR's many new regulatory agencies, the Securities & Exchange Commission, worked with an activist Federal Reserve and raised the collateral requirements for margin. While the number of radios around the world continued to grow, their prices fell. RCA, the highest quality stock in the Radio Boom, declined and did not return to its former peak until the color television expansion in the 1960s.

These and other federal government actions probably turned a secular decline into a fundamental slump, lengthening the depression from its probable end in 1937 and delaying its recovery until the WWII expansion beginning in 1942. Depending on what indicator is used to measure the decline, an important fundamental change could reduce prices by more than 50%. In the case of the Great Depression, prices collapsed by 95% in some cases, if they weren't totally wiped out.

Are there parallels today? The sharp decline in farm income spurred on by NAFTA and tariff changes could be viewed as politically motivated, as is the global impetus to lower interest rates. While the S&P 600 small-cap index was the best performing major stock market index for the decade just ended, it was the worst performer last year. The winner was large caps, with the DJIA and S&P 500 led by their mega-caps. Information technology stocks were up 50% in 2019, about double the average return of US Diversified Equity Funds. Different periods produce different results. The S&P 500's best decade was 1950-1959, gaining +19% compounded. The worst decade was 2000-2009, losing -0.86% annualized.

Help may be on the way from the private sector if the governments around the world don't interfere. Long-term interest rates are starting to rise and at some point they may exert some discipline on the leveraging going on. However, stock markets have not done well historically when central banks have responded to political pressures and made cheap credit plentiful. As equity owners, we are better served by borrowers being disciplined and managing their debts prudently.

Symptoms More Important Than Temperatures

Experienced medical personnel are guided more by a patient's symptoms than by temperature, pulse, and blood pressure readings, as people and conditions can be dramatically different. Consequently, as an analyst I pay much more attention to symptoms than a specific numerical reading. Everything about modern living and markets happens at different rates of change (10% for corrections, 25% secular interruptions and 50% plus for fundamental change). The markets don't readily march to a calendar either, even tax dates are only momentarily important. In evaluating stock markets, it is much wiser to watch people and how they react than fixate on specific numbers.

Contrarian Interests

For investors not involved in competitive races, utilizing a streak of contrary thinking can lead to smaller losses and bigger gains over the long term. On a given day a slow horse can be a winner if it is just a little faster than the others. I often see a change of leadership between small and large-cap securities, also emerging markets and venture capital investments. The most profitable bets are often contrary to the size of their flows. Consequently, I would now bet on energy stocks vs. information tech, small vs. large-cap, emerging markets equity vs. venture capital. Contrarians generally suffer smaller losses.

Question of the week:

Do you know more contrarians who are currently broke or formerly wealthy individuals who are now broke?

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.