Why Routine Stock-Market Declines Make Investors Crazy

(Bloomberg Opinion) -- The psychology surrounding stock-market declines and recoveries is fascinating. Anytime markets retreat even a little bit, the noise surrounding the event begins to swell. Given how frequently markets twist and turn, you might expect people would be used to the occasional plunge by now.

Alas, that simply is not the way human emotions and memory work.

As of today, the Standard & Poor's 500 is a few points away from the all-time high set in September. Lest we forget, there was a 20 percent or so fall from those highs, and a 25 percent move up to close in on that peak. Neither the angst of the decline nor the bliss of the recovery are in any sense of the word rational. As we close in on that prior mark, it might be helpful to consider some details on what pullbacks, corrections and bear markets actually look like -- and why we deal with them so poorly.

First, an important caveat: the terms drawdown, correction, pullback, retracement, recovery have no formal definitions. They're just terms made up by traders and pundits. The convention is 5 percent is a pullback, 10 percent is a correction and 20 percent is a bear market, though these categories have no real meaning.

About that 5 percent: On average, markets fall that much a couple of times each year. A decline of that size barely registers for most people.

Declines of 10 percent are rather common. Data from research firm CFRA notes that in the post-war era, there have been 23 times when the S&P 500 fell 10 percent or more (but less than 20 percent),  or about once every three years. Include all declines of more than 10 percent and such an event occurs about twice every three years.

A fall of 10 percent tends to be short and shallow. Once the decline runs its course, from the short-term lows, the market typically takes about four months to get back to where it was.  This suggests that if the fourth quarter's slump and recovery is normal, then sometime later this month, the S&P 500 should regain that record high mark of September 2018.

My colleague Ben Carlson found that when stocks cross the 10 percent decline threshold, almost half of the time they don't fall more than 15 percent. About 60 percent of the time, according to Carlson, a decline of 10 percent doesn't foreshadow a bear market; 40 percent of the time it does. Perhaps this explains nervousness among investors about a moderate and normal 10 percent decline. Since we tend to fear losses more than we like gains, this might account for the anxiety -- the expectation that worse is to come.

But something else seems to kick in when stocks see a 20 percent decline. Perhaps it is residual post-traumatic stress disorder from the financial crisis. Markets are cyclical after all and -- at least so far -- we have always recovered from what has been proven to be temporary bear markets. But that doesn't make them any less unpleasant to deal with while they are happening. And my fellow scribes don't always help, reminding readers that markets tend to anticipate recessions -- even if they aren’t very good prognosticators.

Our experiences with bear markets vary, from short and sharp to deeper and longer lasting. Historically, U.S. equity markets have always recovered from bear markets. Markets can and do get cut in half; consider 1973-74, when the Dow Jones Industrial Average fell 57 percent. Or the dot-com implosion, when the Nasdaq Composite Index took an 88 percent dive from its March 2000 peak. The most recent financial crisis saw the S&P 500 fall about 57 percent.

Yet, there are troubling exceptions, and this might explain why big declines make everyone so worried. For example, it has been 30 years since Japan's Nikkei-225 Stock Average index hit its high and it remains about 44 percent below its 1989 peak. (And it did take a long time for the Dow -- almost 25 years -- to reach its 1929 pre-crash high.)   

One annoying trope that gets used at times like the fourth quarter is that U.S. markets are turning Japanese, and that a long and maybe endless doldrums awaits us. Of course, this premise never accounts for the fact that in 1989 the price-earnings ratio of the Nikkei was 60 times trailing 12 month earnings. That's more than triple the valuation of the S&P 500 today.

So no, the U.S. isn't turning Japanese, and the probability is that the outlook for markets is bullish. Markets have shown they recover in due time. Eventually, the U.S. will figure out its trade and budget issues -- maybe we'll even get past this moment of political discord. That's the better -- and more rational -- bet to make.

Before the declinethat began in the fourth quarter of 2018.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”

©2019 Bloomberg L.P.