Courtesy of Doug Short.
My recent commentary on four percent and greater declines in the S&P 500 triggered an unusual amount of feedback, much of which has centered on two questions: 1) why pick four percent? and 2) what would a longer look back show us?
The 4% number was an impromptu pick — not the result of data mining but simply a round number that resonates. Now let’s take a much longer perspective than my recent S&P 500 snapshots by switching to the Dow and starting in October 1928, when the Dow was expanded from 20 to 30 stocks. In the chart below I’ve included not only the 4% plus declines but also the intraday volatility, which is measured on the right vertical axis. (Click on the charts below for wider versions.)
A couple of immediate conclusions: First, as a look at the Crash of 1929 illustrates, high volatility is not exclusive to the era of computer trading algorithms. Second, unless you’re a day trader, 4% plus declines are not pre-ordained buying opportunities.
For a clearer look at that distant past, here is a two-decade close-up of the Dow showing the final run to the top in 1929 and the savage secular bear market that followed.
Yes, a few of those 4% declines occurred near major cyclical lows, but most didn’t. Also, there is a definite correlation between the 4% plus days and the downward slopes.
I hasten to add that this snapshot of the Great Depression and beyond is not intended to suggest that the U.S. markets are destined to behave in a similar fashion in the months ahead. We need only look at the 4% plus declines associated with the Crash of 1987 (first chart) to see a period of a high-volatility with no associated recession and followed by a powerful recovery.
Rather, our backward look at the Crash of 1929 and Great Depression provides historical evidence that — depending your investment horizon and risk tolerance — high volatility may signal the need for increased risk management in investment strategies.
