Market suffered an inexplicable foul mood

The stock market survived Black Monday in 1987 because the underlying economy was strong. Odlum Brown vice-president and research director Murray Leith recently told subscribers to Investor’s Digest of Canada that’s why the market will continue to prosper now, even after its record 1,175-point drop on February 5.

Market_Outlook Have you ever used the expression ‘woke up on the wrong side of the bed’ to describe yourself or someone else? It’s typically used to label a grumpy or irritable person, especially when the reason for their unhappiness is unknown. Sometimes the market’s mood turns foul without good reason. We think that was the case in early February, and we believe that it would be a mistake to overreact to the recent market gyrations.

The recent pullback seemed to be triggered by good economic news. The worry, which we believe is overblown, is that the US Federal Reserve will take the proverbial punch bowl away from the stock market party by raising interest rates in the face of stronger economic growth and higher inflation.

The lack of corroborating evidence, our understanding of human nature and, hopefully, our experience are among the factors that calm our nerves, help us to ignore the market’s mood and focus on the fundamentals that matter.

Buy on fear; sell on greed

Investors who sold stocks in early February were behaving as if a recession is around the corner, yet bond, commodity and currency markets are not reacting the way one would expect if an economic downturn were likely. Despite the 10 per cent peak-to-trough correction in US stocks, there hasn’t been the typical ‘flight to safety’ into US dollars, yen, euros or pounds. Nor has there been much movement in developed-world bond yields.

Commodity prices have also been relatively stable, although oil prices have been a little weak lately.

Fear and greed are powerful emotions; it’s human nature to extrapolate trends. We are hard-wired to believe the outlook is good when stocks are going up and bad when they are going down.

Consequently, our thinking typically fuels self-fulfilling behaviour and reaffirms market action as we buy in rising markets and sell in falling markets. The media adds gas to the emotional fire by sensationalizing market movements to increase its audience.

Use the right tool when measuring events over time

We don’t doubt that some investors sold in a panic on Feb. 6 after learning that the Dow Jones industrial average had its biggest daily point drop in history on Feb. 5. The important facts, however, often differ from the headlines.

In this case, it’s the percentage that matters, not the point count. While the 1,175-point decline was indeed large, it equated to less than five per cent—significant, but not worthy of an ominous headline. The Black Monday crash in 1987 was a much lesser 508 points, but in percentage terms the decline was almost five times as bad at 23 per cent.

That was the biggest one-day drop in history!

Keep calm and carry on

From peak to trough, the Dow experienced a 36 per cent decline in 1987. The latest correction was less than one-third that amount as of mid-February.

Looking back at the performance of the Dow over the last 30-plus years, the 1987 crash is merely a blip in a long upward march. Despite the horrific correction, the Dow still returned 5.5 per cent in 1987 (including dividends). Over two years, the total return was 23 per cent, and in three years it was 62 per cent.

Someone lucky enough to own the Dow since 1986 would have a 29-fold gain.

We make the comparison to 1987 because the economic backdrop and investor attitudes were similar to conditions today. The economy was strong, inflation was picking up and the Fed was raising interest rates.

The market had had a huge run-up back then, similar in magnitude to the advance made since US President Donald Trump was elected, and people had become used to a one-way market. When the market hit some turbulence, too many people tried to rush for the exits at the same time, which caused investors to panic.

The market ultimately recovered in 1987 because the underlying economy was strong, and we think the same will be true this time. With any luck, the market’s mood will improve as spring approaches.

Murray Leith, CFA is executive vice-president and director of investment research at Odlum Brown.

This is an edited version of an article that was originally published for subscribers in the March 23, 2018, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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