A bear market was made official last Thursday when the S&P 500 quickly fell below the -20% drop threshold. In the weeks leading up to the bear market and the past couple of days, volatility has raged with many investors asking how much worse could it get and is this the market bottom?
When The Time Comes To Buy, You Won’t Want To
While significant stock market drops have different reasons behind them, a consistent theme across most is how human behavior defines the depth and duration of the tumble. And while it’s impossible to determine the exact market bottom, understanding the phases of human behavior during a market crash can help.
There are typically three stages of human behavior when markets plummet as described by Tony Dwyer, Canaccord Genuity’s market strategist. I believe the current COVID-19 driven drop can invoke the same three-step defined bottom. These three stages of behavior when the market crashes are:
1. Panic – this happens near the end of the initial crash. We are likely closer to the end of the panic phase than the start at this point in my view.
2. Relief – this stage begins post panic as investors are relieved that the market stopped crashing. Numerous relief rallies occur sometimes greater than 25%+ off the panic crash lows.
3. Demoralization – the final test of the market drop when the panic lows are tested again because of the initial round of horrible economic and corporate data.
This three-phase bottoming process takes months as human nature reacts out of panic, relief and then the harsh data. A helpful reference showing this multi-month bottoming process is the 1987 stock market crash which shows how the three stages of behavior shape the depths and duration of the decline.
Doing Nothing Is A Decision
History has shown that there’s no time-tested, successful way to identify the market bottom. However, making constant buy and sell moves can provide an illusion of control for some investors. This constant activity in times of severe market volatility may give an investor a false sense that attractive positive returns are sure to follow.
It’s Been Said That Buy & Hold Investing Is The Worst Kind Of Investing Except For All Other Methods
The Market Bottom Is A Process, Not A Point In Time
The stock market is currently trying to figure out the limits of how much pain humans can take in the current panic-induced decline. Pessimism and optimism usually overshoot because the limits of both can only be quantified in the rear-view mirror. Doing nothing with a properly asset allocated portfolio during market routs is certainly challenging. Making it even harder for investors are the seemingly endless Twitter and CNBC decrees of another “imminent crash!” and “it’s the bottom!” However, by understanding that markets bottom through a process driven by human behavior, navigating the market tumult can require less stress and second-guessing.
This too shall pass and as markets test how much pain investors can take, widening gaps between the true value of great companies and how a panicked market is voting creates great opportunities for investors to exploit.
David Hone, CFA