The US stock market tumbled again yesterday, falling to a 3-1/2-year low, thanks to expanding coronavirus threat.
The economic outlook is grim, at least for the near term, and so the market is attempting to price in this stark change. The result, not surprisingly, is a sobering, rapid fall from grace for stocks, which a bit more than a month ago reached a record high, based on the S&P 500(NYSEARCA:SPY). For the novice investor, the sharp slide in the market may appear to be off the charts. In fact, we’ve been here before, based on drawdown data. Perhaps new records for bear markets will be set in the weeks and months ahead, but for the moment it’s useful to consider how the current drawdown stacks up vs. history. In addition, running simulations on drawdowns adds another dimension of risk analytics to consider what’s possible.
Let’s start with the current drawdown at yesterday’s close (Mar. 23), when the S&P 500 fell sharply, ending the session at the lowest level since Dec. 2016. The decline pushed the S&P’s peak-to-trough decline to -33.9%. That’s a deep cut, even by historical standards (since 1961). But for now, there’s still a fair amount of distance to go before moving into uncharted terrain relative to the past half century-plus.
How ugly will it get? No one knows, of course, although running some basic simulations offers a clue. By sampling the actual S&P 500(NYSEARCA:SPY) history since 1961 and creating an alternative path of drawdown history—and randomly re-running the sim 10,000 times—we can contemplate scenarios that have yet to be seen but may arrive.
On that score, the future could get far more painful for the S&P 500. The boxplot below summarizes 10,000 simulated variations of drawdown, with the deepest decline touching an ultra-severe -97.5%! As the chart indicates, that’s an extremely unlikely possibility, in statistical terms. But given what’s been unfolding in recent weeks, perhaps no one can afford to dismiss the highly unlikely for managing expectations for macro and markets.
Some investors may complain that this isn’t what they signed up for. Really? Well, running simulations on the S&P 500 has long advised that extraordinarily deep drawdowns—beyond what’s been experienced in the modern era—are possible. In 2017, for instance, CapitalSpectator.com published sims on the S&P that reflect the potential for a -97% drawdown.
To be clear, a -97% peak-to-trough collapse is extremely unlikely, even after factoring in recent events. Nonetheless, the possibility for deep losses in stocks was probably overlooked by most investors in recent years—an oversight that’s been corrected via a dramatic real-world attitude adjustment.
The lesson, of course, is that asset allocation and multi-asset class portfolios still matter, more than ever. Holding bonds–Treasuries in particular–has helped minimize portfolio drawdown in no trivial degree.
Perhaps the biggest lesson of late is that maintaining realistic expectations on risk is forever critical, even when a roaring bull market suggests otherwise. That’s obvious now, of course, although it was obvious all along. But there was a catch: you had to be looking and pondering low-probability-but-not-impossible market results.
The world is once again on board with thinking clearly. But this too shall pass, eventually. Wisdom in finance, after all, is cyclical rather than cumulative.