I put this data together a while ago, but I think it is important to keep looking back on it. Let us just make the rather bold assumption that March 9, 2009 was the absolute low closing price during this bear market. What does that mean for the future of equity returns and volatility? I would first like to examine this downdraft versus other historical market corrections of this magnitude. What you notice in the table below is that this is the 3rd worst decline in the S&P 500 or Dow since 1896 at -56.8% from the peak. The Nikkei asset bubble of the early 90’s was worse with a -63.2% drawdown, but by far the great depression trumps all with drawdown of -86.2% over the course of 2.7 years. This brings me to my main point here, that at 1.4 years, March 2009 would have been an early low for the market compared to other major market disruptions…meaning that it usually takes longer for the market to digest all information.
Under the assumption that March was the low, what can we expect going from here? How risky are the markets?
With this current backdrop of economic malady, it is quite possible that the US economy and markets are entering a new paradigm. In fact, risk is simply a measure of future uncertainty. Since the world economies have become so financially intertwined and governments have taken such an active role to influence economic outcomes, the ability to predict market reactions to events has become ever more difficult. In addition, the amount of leverage embedded in many financial markets has created systemic risks which can accelerate market dislocations when certain market factors move further than previous expectations (e.g. re-hedging of leveraged mortgage assets when interest rates change). This would imply that the volatility of the markets will remain inflated from a systemic point of view, that we now have more uncertainty built into the market due to its structure.
If we do not believe that there is a paradigm shift in the markets in general, then we can try to extract information from previous events that were similar in nature. The great depression was experienced for nearly a decade in the 1930’s after a tremendous amount of wealth was destroyed in the stock market crash of 1929. After such a large asset price correction there were years of self-propagating deflation and negative GDP growth. It was only after the onset of World War II that per capita GDP reached pre-depression levels. It can be argued that tight monetary conditions prolonged and worsened the magnitude of the depression, but regardless, markets remained volatile for nearly a decade after the market hit its low in 1932 as shown in the graph below.
As a second historical comparison we can look at the Nikkei during the 7 ½ year time period after it reached its low. The Nikkei was less volatile than the S&P 500 during the great depression, but with many false starts (of 50% magnitudes) followed by subsequent retesting of lows.
Spend time analyzing the charts above and recognize that years after the bottoms were reached there was significant volatility in both markets. If volatility has truly relaxed to its rather calm levels (currently sitting at about 18% from a monthly perspective) then I will be very surprised. I think we are in a lull within the storm.