UPDATED: 10/29/2008

Stock Market Turmoil

The massive losses on subprime mortgages, decreasing home prices, subsequent collapse of various financial institutions and difficult credit conditions have led to a steep market decline, which has accelerated in October.

Drawdowns

One way to quantify the decline in the stock market is to measure the maximum drawdown, the percentage decline from the highest peak to the lowest valley after the peak.

The current maximum drawdown on the Standard & Poor's 500 Index has the dubious distinction of being the third worst since 1970. From the peak on October 9, 2007 through October 27, 2008, the S&P 500 Index declined by 45.8 percent.

Figure 1 below shows the worst 10 drawdowns on the S&P 500 since 1970, as well as the presumed catalyst or key events of the time, and whether or not there was a nearby recession.
 

Figure 1

* Using Yahoo adjusted closing prices.

The current drawdown from October 9, 2007 to October 10, 2008, at 367 days, is the fourth longest to date since 1970.

Which Drawdowns Were Worse?

Internet Bubble Crash

The rampant speculation in technology stocks, and resultant excessively high valuations, led first to the internet bubble and then to the internet crash. At the stock market’s March 2000 peak, the price/earnings ratio of the S&P 500 Index, using trailing 12-month reported earnings, was a whopping 29.4. The average since 1927 has been 16; for the past 25 years it has been 21.

On September 30, 2008, the P/E ratio was 22.1. By October 27, 2008, it had slipped to 16.1, below its 25-year average.

Oil Embargo

While the internet crash was caused by unduly high stock prices, the stock price decline in the early 1970s was precipitated by a shortage of a fundamental economic commodity – oil. During the oil embargo of the early 1970s, the world’s oil supply was effectively decreased by over two million barrels per day, causing unbearably long lines at gas stations and major economic disruptions.

Five- Day Drawdowns

There has been an especially steep decline in the S&P 500 Index this month.

Figures 2 and 3 show the 15 worst five-day drawdowns (with worst at the top) and the 15 best five-day increases (with best at the top), in the S&P 500 Index since 1970. The data goes through October 27, 2008. Note that multiple five-day drawdowns may be associated with the same event, such as those associated with “Black Monday”, October 19, 1987.

Figure 2

Figure 3

Were the worst five-day drawdowns soon followed by healthy five-day increases? Find the month and year of a drawdown, and then look for a corresponding increase that took place soon afterwards.

The October 1987 drawdowns (numbers 1, 2, 5, 6, and 10 in Figure 2) were offset in part by a 12.3 percent increase over the five days ending November 2, 1987 (Figure 3).

The October 2008 drawdowns that we are suffering through are numbers 3, 4, 7, 8 and 9. While the S&P 500 was up 10.8% on October 28th, there was still a negative return for the five days ending October 28th. Only time will tell how (and how soon) the markets recover.

The 11th worst drawdown of 12 percent ending on August 31, 1998 was offset by a five-day increase of 9.2 percent ending on October 15, 1998 (which was the 17th best five-day increase, so it is not in the table above).

The 12th worst drawdown of 11.6 percent ending on September 21, 2001 was followed by a five-day increase of 7.8 percent ending on September 28 (not in the table above).

The 13th and 14th worst five-day drawdowns occurred in July 2002, with losses of 11.5 percent. These were swamped by a 13.2 percent five-day increase ending July 30, 2002.

The 15th worst drawdown of 10.5 percent ended on April 14, 2000. A five-day increase of 6.9 percent, not shown in the table, ended June 2, 2000.

The point? Within about two months of the worst five-day drawdowns, healthy increases typically have offset some or all of the loss.

Conclusion

We are going through a gut wrenching downturn in the markets. Our government as well as European countries have enacted various programs to help. Governments may very well institute even more action to aid the markets. While the odds of a recession are high, stock prices already reflect the widespread expectations of future weakness in the economy. 

We cannot predict the length and severtiy of the recession, nor the short-term performance of the stock market. However, history tells us that, just as the sun breaks through after a major thunderstorm, major buying opportunities tend to follow major panic selling. Those opportunities have always been recognized and sought by investors.

In the past, markets ultimately have stabilized, corrected and started to improve after a downturn. We don’t have any reason to believe this time will be an exception.
 

Larry Katz is the Director of Research for Merriman Berkman Next