February 26, 2020
Market Correction, Crashes, Bear Markets and Recession: Kernel Explains
Dramatic events, market correction, misunderstanding of risk and fear of the unknown have kept – and still keep – many Kiwis away from investing. These factors have the everyday investor believing it is risky and a game for gamblers or reserved for the wealthy.
We thought we would demystify it, so here Kernel explains crashes, market corrections, bear markets and recession . Knowledge is power and by understanding the risk, you will be better placed to benefit from the profits of the largest companies in the world.
We also want you to see how easy and stress-free it can be. Our mission is to empower the financial future of millions and build products that enable great long-term wealth creation.
Fear & loss sell newspapers
It is worth reminding ourselves that fear and loss is much more newsworthy than normal life and the random walk of the daily stock market. Stock markets have a habit of creeping slowly up, but “crashing” down loudly and unexpectedly. While tech advancement, macro prudential interventions and increased sophistication have supposedly stabilised markets, there is still a fear of the unknown. This fear impacts the value of assets, especially assets that are “mark to market” such as shares.
First we will start with these negative terms, and what they actually mean. Then we will look at the key decision the average person should make to protect themselves. Finally, we will bust some myths about how index funds, will perform through these periods and affect the market generally.
What is a market correction?
A market “correction” is commonly defined as a decline of more than 10% of the price of the most recently sold share from its previous peak. So, if a share price rose from $1 to $2 and then fell back below $1.80, it would be called a market correction. The same for an index.
If the index value, like the S&P/NZX 20, was 5785 in January and rose to 7692 by December, falling back to below 7000 would be a market correction.
According to a 2018 CNBC report , the average market correction for the S&P 500 lasted only four months. Values fell around 13% before recovering.
A bear market explained
A “bear” market is simply the opposite of a “bull” market, where the general trend is down rather than up. The bear aspect is that a bear swipes its paws down, while a bull lifts its horns up to attack.
If you believe in economic prosperity, long term growth and capitalism generally, bull markets outnumber and are longer than bears. To put a number on it, a decline of 20% or more from the market’s highest previous point is a bear market.
Looking at rolling one year returns for the S&P 500, where long term data is available, this threshold has been crossed in 27 years out of the last 100. But only 7 years since 1980.
Should I worry about bears?
It is easy to see why the individual or non-professional investor worries about a 10% or greater fall. It feels like a significant amount, and fear and regret may set in. The investor didn’t see it coming and doesn’t know how long the market correction will last.
This is especially the case if the portfolio value falls below the initial invested amount, from a combination of the behavioural biases called loss aversion and anchoring. It is a strong emotional effect, where we extrapolate trends as linear and feel an urge to protect the remainder.
The tendency is to pull out and stand on the sideline in cash or move into more defensive assets. However, this is attempting to “time the market” and often it will compound the negative effect through transaction costs incurred and missing the rebound.
It’s a small pot hole
For most investors in the market for the long term, a market correction is only a small pothole on the road to wealth creation. Unless you suddenly believe in the end of capitalism or civilisation, there is no reason to change your asset allocation due to external events.
A market crash
This brings us to the more extreme end of events, the “crash”. This is when a correction dramatically occurs in a matter of a day or days, across a cross-section of the stock market. Crashes are driven by panic and fear of the unknown, as much as by interpretation of news or underlying economic factors.
Sensational headlines abound with images of tortured faces and cliff jumping, both graphically and literally. It absolutely can be disastrous and career ending or bankrupting, for those who are extremely leveraged through derivatives or borrowing. However, not for the average investor with a normal portfolio and asset allocation and unchanged personal circumstances.
While troubling and unpleasant, it should not be of great impact. If history teaches us anything, it’s that this can actually be an opportunity to buy bargains. This is so where the “market” has often overreacted to news and where many more want to sell than buy. That said, this is also trying to time the market. Generally investors sell too late and buy again too late as well, missing the recovery and hurting their performance.
Overall, at Kernel we recommend regular habitual savings through auto-invest where you benefit from dollar cost averaging.
Investing and recession
Finally, for our definitions of these unhappy words, recession. A recession is a macroeconomics term, not an investing term. It is where national economic growth, or change in GDP, is negative for 2 or more quarters in a row. Sometimes the stock market follows and sometimes it doesn’t. This can depend on the view of the future profitability of the companies, the actions of government and central bank.
How to protect yourself
A fear of the negative drives many decisions, both individually and collectively. So, what can the average person do to protect themselves from being affected by them?
Our advice is simple – let your financial situation and needs drive your investing behaviour.
Not a reaction to events in the markets. Why sell when the buyer will want a significant discount because of current uncertainty? Otherwise you are attempting to time the market. What is important is that you periodically review (about annually is ideal) your asset allocation. Restrain yourself from getting caught up in the noise of the headlines, the latest event or the view of an “expert”.
As a rule of thumb, any money that you must spend in the next three years should be in lower volatility investments, such as a term deposit.
Anything with a flexible withdrawal date, or further than 3 years away, can be invested in medium risk options, such as index funds. The reason being, that your investment in most scenarios will recover to a higher average return if you can wait long enough.
it is also prudent to have emergency savings, so that you don’t need to sell an investment at an inopportune time, to pay for an unexpected expense.
So what about index funds?
Index funds do not trade more in negative periods. In fact, on the contrary, active funds can double the sell down effect. This can create market distortions and activity not aligned to the company’s true value.
When a market is in crisis, there is a natural tendency to run for the door and turn investment into cash for “protection”. An active manager does this for two reasons. One, to create cash to satisfy the investors who are withdrawing. Two, to attempt to time the market by holding a cash reserve to taper the negative performance.
An index fund, meanwhile, only does the first, and therefore creates less market activity in time of uncertainties. There is little to no evidence that an active manager, on average, does successfully time the market. Often they just incur extra costs and risk missing the rebound.
As for the activity caused by redemptions, there is no reason this should be higher for index funds than active funds or direct shares. This would be due to the attitude or sophistication of the investor or the advice they are receiving. As we will explain below, the activity in index funds is likely to be lower.
Index fund trading
Another misconception is when an index fund trades. An index fund is not buying and selling every day. Only when it has net applications or redemptions, or the few times a year that it re-balances to the index. The valuation is changing as the underlying share prices change, not from changes in the number of shares held.
Liquidity issues are nonsense
The greatest fear mongering of all is around supposed liquidity issues caused by index funds. The theory goes that if lots of investors want their money out, index funds and ETFs could not cope with the demand, therefore becoming frozen.
This ignores three aspects. First, that ETF products are a store of value on their own and do not have to be unbundled and sold. Second, that active managers face the same issue of having to suspend withdrawals if they can’t sell the investment. Third, that most index funds including Kernel’s, contain legal provisions to handle distress.
Bubbles of valuations
Another accusation thrown by those with vested interests is that index investment creates bubbles. For example, a company represents 10% of an index, the fund must invest new cash in that company and as a result that company becomes overvalued. This ignores some quite important facts.
First, despite a company increasing in value, the index fund still buys the same number of shares proportionally. Quarterly rebalancing is more likely to reduce that than exacerbate it. Second, the index share of market trading is estimated to be well below 10%, nowhere near enough to distort prices. Third, index investing is not one thing, with many different sectors, factors and varieties available. Finally, a share is only worth what an investor is willing to sell it for.
We are not seeing the concentration on the share registers to support theories that active holders are reducing holdings in larger companies, because they feel they are overvalued, and it is only index holders that are buying at any price.
In closing, the dangers of index investing are hyped and misinformed by those who have the most to lose from the growth of index investing. Or as Morningstar was quoted in Fortune magazine recently:
“The danger is chiefly one faced by Wall Street: That they’re going to get paid less and become less relevant over time. If anyone is in peril, it’s largely the people who have been vociferous, oftentimes shrill, about the rise of indexing.”
Our final thought is a classic quotation from a namesake:
“It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
Upton Sinclair, 1935
Chief Operating Officer