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Could the market go to zero?

Do the current state of things have you exploring ‘what if’ scenarios? Larry Swedroe shares his thoughts on how low things can go on the stock market.

Transcript

Tim Maurer:
Tim Maurer back with another episode of Ask Buckingham. A new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Larry Swedroe, Buckingham’s Chief Research Officer. And Larry, we have seen some historic down days. Down days where the market was going down so precipitously, so fast that one might even beg the question, am I going to have something to come back with? Could the market actually go to zero in any circumstance?

Larry Swedroe:
When you get questions like that, Tim, I think the best thing to do first of all is to recognize Swedroe’s first law of investing which is to never treat the unlikely as impossible. So markets have gone to zero. Just think of Russian stock market before 1970. I think I have enough faith in our capitalist and democratic system, that we are not facing that kind of Armageddon. So let’s turn to looking at the lessons history can provide us in thinking about what might happen. And one of the things is important if anyone is looking for some guidance about what will happen. If somebody’s telling you what will happen as a guru or forecaster from some investment bank or money manager then you should immediately ignore it.

Larry Swedroe:
Because nobody knows what will happen. The smartest people are the ones who are always uncertain. And they talk in probabilities and dispersions of potential outcomes. So that’s what I want to do today is we’ll answer that by talking about the three types of recessions and bear markets and look to see what history tells us. So get some guidance each bear market is unique in its own way. So you can’t predict exactly, but we can get guidance because we have had many of these crises. I estimate will we’ve had over 20 of them in the last 40 years or so. So let’s start with the first kind, is a normal cyclical recession where we come out of a recession. We have a lot of underutilized resources both manufacturing and labor, and no price pressures until we reach ultimately maybe five, six, eight, 10 years later.

Larry Swedroe:
We’ve had this boom, we run out of capacity. Workers are in great demand, unemployment is low, so they put pressure and we get rising wages manufacturers raise prices and the Fed is now concerned about inflation, which you’re have to get it under control. Or you worry about looking like Weimar Republic in Germany and nobody wants that. So the Fed comes in drives real interest rates way up, we get a cyclical recession. That’s the first kind during such bear markets like that the average period is about three to four years to get recovery.

Larry Swedroe:
And the average earnings drop is about 30, 40, 50% or so. Might be a bit higher but somewhere in that range. And by the way, the average bear market overall is down 35% and we got to about that level last week. Alright, the second type is more of a structural type of recession like we had in a way. Big shock to the economy caused by a shock to the banking system. Their recoveries take a bit longer and they tend to be a bit deeper on the earnings side. So we may see more 50, 60% plus drops in earnings. And it takes maybe a full five years for earnings to now recover. The third kind is the kind that we’re experiencing now which is an event driven, you might think of 911. Interesting enough on average they tend to only last about a year, with earnings dropping about 30%. So not as severe, but this couldn’t be much worse.

Larry Swedroe:
We’ve never faced a pandemic like this one so we don’t know. But as I said, the average bear market is 35%. But I’ll give you some further evidence that might help give people confidence that the light at the end of the tunnel is not that proverbial truck going the other way. So if we look at ’08, we were in ’07 earnings were at $83 for the S&P 500. By ’08 they had dropped to 50. Real sharp drop in that 40 to 60% kind of range. However, by 2010, we’re at 84. Two years we’re ready back right after the worst financial crisis, worst recession since The Great Depression.

Larry Swedroe:
Then if we look back at 2001, that event. If we look at 2000, earnings were … Let me say, earnings were at 56 in ’01 they dropped sharply to 39. Again, in that same kind of 40 years 50% kind of ranges. And yet we were right back by 2003 we were making right back to 55, so within $1. So that would be more typical, although we have that others that have gone three, four or five years. Nobody knows what will happen. So we’ll just present three quick scenarios.

Larry Swedroe:
One is we get is V-shaped recovery like we had in ’01 through ’03. Sharp drop down quick recovery because the structure of the economy was not damaged. And you can get a bit more of that U-shape recovery of like we had in ’08, all of our earnings did come back pretty quickly there. But takes a longer we had much slower growth of the economy after that, because there was a lot of structural damage. And then this is one we haven’t faced, at least since The Great Depression. But Japan is facing you could get that L-shaped recovery.

Tim Maurer:
Nobody wants that one. [crosstalk 00:06:59].

Larry Swedroe:
And nobody wants that one. If you asked if it’ll go to zero, I would say, almost impossible. Could it be an L? I would put a low probability on that. But it will depend partly on how long this lasts, we’re going to have to spend about a trillion dollars a month to offset the lack of demand from the shutdown on the economy. That’s a big number. If it lasts two or three months, I think the damage will be relatively minor. And but we’ll have added two trillion more of debt, at least. And that will act somewhat of a drag on the economy, but we’re a huge economy I think we could survive that. If it goes a long time, we could end up more like Japan because of structural damage, massive debt possible but not likely in my opinion.

Tim Maurer:
So Larry, when we look at this history it helps give us perspective which I think expands our horizons, illuminates our imagination a little bit about what could potentially happen. But I am curious in these lessons of history, what application might there be for us as investors today?

Larry Swedroe:
Yeah, I think the perfect application is to just follow Warren Buffett’s advice. And here we have what I think is the greatest anomaly in all of finance. Which is people idolize Buffett, most people when asked who would you say is the greatest investor? They would say Warren Buffett yet so many people not only ignore his advice but they tend to do the opposite. So Warren Buffett’s advice is never try to time the market. But if you can’t resist that urge you want to buy when and there’s blood on the street and everybody’s panicking. And we just saw yesterday, we saw that Buffett has been buying like most people think he’d be crazy. It’s the airlines have been hit the highest and they have a lot of debt. So they could be really suffering perhaps because of their high leverage.

Larry Swedroe:
So but he’s buying because valuations are so low. The problem is you will never see where the bottom is. So here’s something that I think can be really helpful for investors is to understand that markets recover much faster than the economy does. And by that, I mean, we know today that the recession of 2008 ended officially in June, end of the second quarter of ’09. We didn’t know that because the National Bureau of Economic Research doesn’t get all the data finally, maybe it was October or something like that. But the unemployment rate even kept rising right up to 10% right through the end of the year.

Larry Swedroe:
So we had almost, we had 10 months between March 9th, and the end of the year basically, when the economic news didn’t even get good it just stopped getting bad. And the market began one of the greatest recoveries ever. So if you waited until the unemployment peaked you would have had a wait till January February to see it’s not coming down, you would have already missed a big part of the economic and stock market recovery. And we saw that by the way, the last three days if you got out on Monday because you’re panicked and reach your point of your stomach screaming get me out, you would have already missed 20%. Now that’s two years of average returns. One last interesting point, data point we can share. Study was done on 100 years of market returns. That’s 1200 months, if you out the best 100 months, not necessarily one month each year, but the best 100 months, the other 1100 months had a cumulative return of zero.

Tim Maurer:
Wow!

Larry Swedroe:
So the odds of you being able to capture that eight and a half percent of all the months, I think we’re going to agree are zero. And therefore the best thing to do is have a well thought out plan that doesn’t take more risk than you can stomach. You can sleep well because your plan is prepared, you have that plan B. If things turn really bad what are the expenses I’m willing to cut? And that will allow you to maneuver your way through this because you shouldn’t be investing in stocks in the first place unless you have ultimate faith in our capitalism and our democracy. And I know I do every other crisis we’ve ever faced, we’ve fought and won and comeback on new highs, actually within a reasonably short time a number of years.

Tim Maurer:
Larry, thank you so much. I appreciate that perspective that history offers us but also the present day recommendations. And I especially appreciate that you’re not just an endless market cheerleader, you’re suggesting that your exposure to stocks should still be within your personal framework of risk tolerance. But then once you have made that termination, it is important to be willing to stick to a course once you’ve made it. Thank you Larry Swedroe, and thank you for tuning in to this episode of Ask Buckingham.

Tim Maurer:
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