Learnings from Stock Market Crashes Across 68 Countries and ~1900 Years of Data May 2019 By: Maneesh Shanbhag, CFA Summary • We studied almost 1900 years of equity markets data across 68 Developed, Emerging, and Frontier countries • On average across countries: o Smaller corrections of 10-30% occur every 2-4 years, and recover within months o Big crashes of 40% or worse occur on average every decade, and recoveries can take 5- 10 years or longer • The two main causes of market crashes are debt crises and bubbles; these are the events investors need to prepare for to avoid permanent loss • Crashes tend to be global, so all markets are affected. Global diversification does not reduce exposure to this risk. Diversification within equities is overrated while diversification across asset classes is under utilized Introduction Investing is risky, but all risks are not the same. We think investors are overly fearful of the ups and downs in markets. Most of this volatility is just noise where prices recover quickly. The big market crashes are caused by economic crises and therefore can take many years to recover from. This paper is a study of both shallow and deep market drawdowns and what investors should do about each one. Many people consider the daily price movements (i.e. volatility) of publicly traded assets as risk. This risk is temporary, and it is significantly less important than the risk of permanent loss, which can change the trajectory of your returns forever. For this reason, we are most concerned about the risk of permanent losses and think most investors should be, too. And in public equity markets, this is caused by the big drawdowns of -40% or more, which often take years or even decades to recover from. It’s interesting to note upfront that long periods of flat returns, which erode investor purchasing power over time, never happened without a big crash in stock markets. Some investors choose to trade, hedge, or time these events, often through strategies with high fees or that earn no long-term return. However, instead of helping to avoid the crashes, these strategies often guarantee this type of permanent loss. One example is private equity which has a high risk of permanent loss from leverage and high fees (6-7%1), but without any of the temporary losses from wiggles in daily prices like stock prices. By applying the learnings from our research, overlaid with logic and common sense, we hope to provide a more effective investment approach to protect against these crashes and permanent losses. A study across time and place After the 20% dip in the stock market last Fall and seeing investors panic for the first time in many years, we wanted to measure how often real panics occurred historically. We studied the local currency stock market returns across 68 developed, emerging and frontier countries, ranging from Canada to China to Colombia and Kenya. For most developed markets, data starts in 1970 (49 years each) and with US data 1 https://www.regjeringen.no/contentassets/7fb88d969ba34ea6a0cd9225b28711a9/evaluating_doskelandstromberg_10012018.pdf Greenline Partners, LLC New York · Seattle 1 starting in 1926. Most other countries have data back to 1998 but sometimes less. In total, we analyzed 1878 years of individual country stock market returns for crashes of various sizes. A table in Appendix A shows each market we studied and details for each index. We present three learnings from this study that we hope is useful to investors: 1. The frequency and length of drawdowns of various sizes. We measured this for all markets, and hope the findings are useful ahead of the next downturn in global stock markets. 2. Understanding the causes of the big crashes - drawdowns of -40% or more and which took at least 3 years to recover from. 3. Ways investors can prepare for crashes. We note some general observations about different ways to diversify and their effectiveness. Why the big crashes matter and the rest should be ignored A true market crash is different than ordinary wiggles. They have only a few catalysts that do not precede typical market dips – debt crises and the bursting of bubbles. Our former colleagues at Bridgewater Associates have written in depth about the mechanics of these economic crises and we encourage you to review their materials2. To illustrate the difference between crashes and other market dips, we show a chart of the peak-to-trough drawdowns for the US stock market back to 1926. There were only 4 instances of drawdowns -40% or worse over this period (5 if you count the crash of 1937) but many smaller dips. That’s less than one crash every 20 years, and only ~2 crashes during an average investing lifetime. Furthermore, the US stock market recovered from all these crashes. US stock market drawdowns since 1926 0% -10% -20% -30% -40% -50% Down -40% or worse Drawdown -60% -70% -80% Source: Bloomberg, Ken French Data Library This can make it seem like crashes are not events to worry about, and that buying and holding the market is the best long run strategy. However, our experience in the US has been somewhat unique, and not all markets have been so fortunate. We have a diversified economy and the most developed capital market in the world, combined with some historical luck that may not repeat. 2 https://www.principles.com/big-debt-crises/ Greenline Partners, LLC New York · Seattle 2 The charts below show some of the other markets that have gone 10, 20, even 30+ years without fully recovering. It is noteworthy that Japanese markets have still not recovered from their asset bubble and resulting debt crisis of 1989. As we will see, this crash was caused by all the specific drivers of big crashes. Japan - 30 years into recovery Greece - Still down 90+% since 2008 1969 1978 1987 1996 2005 2014 1998 2003 2008 2013 2018 0% 0% -20% -20% -40% -40% -60% Drawdown Drawdown -60% -80% -80% -100% Italy - 10+ years into recovery Finland - ~20 years since Dot.com 1989 1994 1999 2004 2009 2014 1987 1992 1997 2002 2007 2012 2017 0% 0% -20% -20% -40% -40% Drawdown Drawdown -60% -60% -80% -80% Source: Bloomberg, Greenline Partners analysis Suppose, as a US investor, you don’t believe we will ever experience a crash from which we will not recover. Is there still a reason to care about these crashes? Yes, because crashes contribute to long periods of low returns which erode purchasing power and increase the odds that you won’t reach your financial goals. The chart below shows rolling 10-year returns for the US. We can see that all the 10-year or longer periods of low returns coincide with a big crash. Greenline Partners, LLC New York · Seattle 3 US Stocks over rolling 10-yr periods 25% 20% Coincides with 15% crashes of 1929, 1937 and Great 10% Depression 5% Return, annualized 0% Coincides with Nifty -5% Fifty crash (1973) Coincides with Dot.com (2000) and subprime (2008) crashes -10% Source: Bloomberg, Ken French Data Library Crashes cause investors to panic. They change future investor behavior as well as regulations and policies of central banks. Most investors, often because of the structure of their portfolios, are not able to hang on during a crash and it’s this selling pressure that turns the dip into a big crash, leading to losses. For institutions and retirees with regular cash needs, these sizeable drawdowns are an unacceptable outcome. Corrections vs crashes: Understanding the differences, frequencies and recovery times We analyzed stock market returns in 68 countries and counted all the drawdowns of various sizes and then attempted to understand the drivers of every crash worse than -40%, over 125 in total. Market Corrections: Frequent with short recoveries We find many investors fear even small ups and downs (the popularization of trading by the media is certainly no help), so we review smaller corrections of at least -10% to crashes of -40% or more. The table below summarizes the average frequency that these drawdowns occur across Developed, Emerging, and Frontier markets. The main takeaways are: • Equity markets, on average, have fallen -10% or more only every 2-3 years • “Corrections” of -20% have occurred about once every 4-5 years (most recently in the US in 2011 and 2018). Almost half of these bear markets are big crashes that happen about every 10-20 years. • ”Crashes” of -40% or more, are relatively infrequent. Frequency (years) Developed Emerging Frontier Drawdown <-10% 2.8 1.9 2.3 Drawdown <-20% 5.4 3.9 4.3 Drawdown <-30% 9.3 6.7 7.3 Drawdown <-40% 14.8 10.7 9.9 Source: Bloomberg, Greenline Partners analysis The table below summarizes the recovery times from Corrections (-30% drop or less) compared to larger drawdowns. The average recovery time from drops up to -30% is barely a year, whether talking about Developed, Emerging, or Frontier markets. Crashes on the other hand take multiple years and sometimes decades to recover from. Greenline Partners, LLC New York · Seattle 4 Recovery Time (months)3 Developed Emerging Frontier Correction (drawdown up to -30%) 14 9 10 Crash (drawdown worse than -30%) 70 55 94 Source: Bloomberg, Greenline Partners analysis We think the frequency and recovery time statistics are extremely useful. You can see that, on average, recovery from smaller corrections in market prices takes months, not years. Given this reality, we believe investors would benefit from largely ignoring the onslaught of daily news, which is filled with fear and anxiety-producing noise. The best strategy is not to time these corrections, but rather to buy and hold through them.