Image credit: Detail from French illuminated manuscript of Boccaccio, late 15th century, Bibliothèque Nationale de France
By Jason Zweig
12:37 pm ET Oct. 10, 2014
This week’s market turbulence, in which the Dow Jones Industrial Average fell 273 points, regained 275, then lost 335, is long overdue and should be utterly unsurprising.
Other than a brief setback in late January, stocks have marched monotonously upward this year—and have long been in one of the smoothest bull markets in history.
As market strategist Nicholas Colas of the ConvergEx Group points out, the VIX index—the “fear gauge” that measures market volatility—has spent almost the entire past three years below its long-term average of 20. And even after the market’s wild midweek swings, the fear index is still about 19. (It went as high as 80 in late 2008.)
Before this latest patch of turbulence, the S&P 500 had racked up more than 60 trading days without a single 1% move on a daily basis—the longest ride so smooth since 1995, as my colleagues Steven Russolillo and Kevin Kingsbury pointed out yesterday.
Other indexes have been similarly calm. Although the Nasdaq Composite Index fell 2% yesterday, it has dropped at least 2% in a day only six times, or just 3% of trading days, in 2014, according to Doug Ramsey, chief investment officer at the Leuthold Group, a research and asset-management firm in Minneapolis. In 2009, the Nasdaq had moves of 2% or more on one-third of its trading days; in 2000, it had such moves on half of its trading days.
A ride as smooth as 2014’s is profoundly abnormal. As of last night, the S&P 500 had fallen 4.13% from its all-time high closing price of 2011.36 on Sept. 18, 2014. Since 1927 there have been 425 drops of 4% or greater, or one every 75 days, says analyst Jeffrey Yale Rubin of Birinyi Associates, a research firm in Westport, Conn. The average loss in those declines has been 8.9%, and they have lasted an average of 27 days. In the current bull market, which began in March 2009, the average decline has been only 6.8% and has lasted just 19 days.
Mr. Ramsey points out that since 1928 there has never been a year during which the S&P 500 hasn’t lost at least 2.5% at some point before year-end; the average “intrayear” or interim loss was 16.7%. Yet the market finished up in 62 out of those 86 years—even in 1987, when the S&P 500 fell 33.5% between Aug. 25 and Dec. 4. The S&P 500 still delivered a positive total return of 5.2% for the full year in 1987. Likewise, in 2010 stocks slumped 16% between April and July, then finished up 15.1% for the full year; in 2011, the market sank 19.4% between April and October but still squeezed out a 2.1% gain for the entire year.
It’s also worth pointing out that U.S. stocks dropped by 5.8% between Jan. 15 and Feb. 3 of this year—but that no one got bent out of shape then because it happened gradually rather than in dives of 275 points or more on the Dow.
None of this means there’s nothing to worry about, however.
The first thing to worry about is just how lucrative the stock market has been. Even after Thursday’s tumble, the S&P 500 has returned 6% in 2014 and 18.8% over the past 12 months. It has delivered an average of 21.2% annually for the past three years and 14.9% for the past five. All these figures, from Morningstar, include reinvested dividends.
Such high returns tend to numb the sense of risk that investors normally feel. So far this year, the stock market has shrugged off sluggish U.S. economic growth, the military onslaught of Islamic State, tension between Russia and Ukraine, protests in Hong Kong and deep stagnation in Europe.
What’s more, five years of hot returns have driven the stock market to high valuations. Even after the market closed sharply down yesterday, the S&P 500 was trading at nearly 26 times its long-term average earnings, based on data from Yale University economist Robert Shiller. That’s about 50% higher than its historical average and signals cause for concern, says Prof. Shiller.
On the other hand, Prof. Shiller emphasized to me in recent interviews, today’s higher than long-term average valuation isn’t a clear sell signal. And, he emphasized, stocks aren’t in a dangerous “bubble,” which he has defined as:
A situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.
Prof. Shiller added in a telephone conversation yesterday that he is “watching carefully”—not so much what the market does, but the stories people tell themselves and each other about what it does.
The clearest sign that the housing bubble might burst, he said, was that his surveys found that “there was a sudden surge in people’s talk” about just that possibility. If fears about economic growth suddenly become more widespread, that could spark a “social epidemic” that could mark a similar “turning point” for the stock market, he said.
Prof. Shiller reports the monthly results of his surveys on the confidence of stock investors here.
Given how frequent these market stumbles have been in history, most investors should probably do nothing.
Prof. Shiller does think it pays, in the long run, to have more money in cheaper stocks, so he owns—and says he is still comfortable with— iShares Italy and iShares Spain, exchange-traded funds investing in two of the world’s lowest-valued markets, and Vanguard Industrials and Vanguard Health Care, ETFs that hold U.S. stocks in market sectors that Prof. Shiller’s recent research suggests are cheaper than their long-term average valuations.
Source: WSJ.com, Total Return blog