Market Meltdowns: Do They Signal Bargains or More Pain Ahead?

Have you ever experienced a significant loss in the stock market? It’s not a fun feeling, and it can make you want to avoid risky investments altogether. But here’s the thing: avoiding risk might not always be the best approach.

You see, our brains are wired to remember negative experiences more strongly than positive ones. This means that if you experience a major loss in the market, you’ll likely be hesitant to invest again in the future.

However, many experienced investors argue that the best time to invest is when the market is down. They say that buying stocks at a discount can lead to outsized profits later on. So, who’s right?

To answer this question, let’s take a look at some historical data. The table below shows the worst annual returns for UK equities since 1871, along with the returns for one, three, five, and ten years after each of those bad years.

Bad yearReturn (%)+1 year (%)+3 years (%)+5 years (%)+10 years (%)10yr annualised (%)
1916-17.4-12.5-13.8-36.250.14.1
1920-31.88.671.1137.7181.210.9
1931-16.537.899.7167.678.56
1937-15.9-11.2-28.4-12.311.11.1
1940-18.610.831.549.235.93.1
1969-16.2-9.431.8-62.7-12.1-1.3
1973-34.2-57-22.51.275.95.8
1974-57103.4132.6135.4415.717.8
2002-23.218.65783.574.95.8
2008-32.226.22965.387.26.5
Real total returns (GBP) from MSCI. February 2023

As you can see, the severity of the first year’s losses doesn’t necessarily predict what’s coming next. For example, the worst year for UK equities (1974) was followed by the best year in history (1975). Meanwhile, the second-worst year (1973) led right into the 1974 crash.

So, what does this tell us? Well, it suggests that severe market shocks can abate fairly quickly. In the best cases, bold investors quickly see that the panic has been overdone and start buying, which restores confidence among the rest of the market and leads to further gains.

But sometimes, mild hits don’t flush enough negativity out of the system within just a year. In these cases, escalating disquiet can lead to a deeper decline in year two.

Ultimately, a recovery is usually underway three years after the initial slump. In fact, seven out of ten aftermaths featured high single- to double-digit average growth. But it’s important to note that there were still three events that were poisoning the water supply five years out, and one that was still affecting returns after a decade.

What about global equities? The table below shows the worst annual returns for the MSCI World index since 1970, along with the returns for one, three, five, and ten years after each of those bad years.

YearReturn (%)+1 year (%)+3 years (%)+5 years (%)+10 years (%)10yr annualised (%)
1970-10.22.1-2.2-25.3-37.9-4.6
1973-22.6-38.1-10.5-27.87.20.7
1974-38.123.416.10.8116.88
1977-19.70.6-11.515.8136.29
1979-13.71.933.4115.1311.115.2
1987-11.822-2.626.5112.57.8
1990-35.51459.18321312.1
2001-15.6-28.7-11.38.840.4
2002-28.718.149.460.457.44.6
2008-20.312.414.150126.88.5
Real total returns (GBP) from MSCI. February 2023

Again, we see that the worst routs often lead to the best rebounds. However, it typically takes five years before a majority of sample periods turn positive. And at the ten-year mark, three of the timelines were all told a thankless slog.

So, what about UK government bonds? The table below shows the worst annual returns for UK gilts since 1871, along with the returns for one, three, five, and ten years after each of those bad years.

YearReturn (%)+1 year (%)+3 years (%)+5 years (%)+10 years (%)10yr annualised (%)
1916-32.5-17.7-36.7-35.28.60.8
1917-17.7-7.5-38.36.144.83.8
1919-16.8-19.73865.498.77.1
1920-19.727.490.5106188.111.2
1947-19.9-6.5-17.1-38.3-50-6.7
1951-17.2-10.22.3-19.3-31.7-3.7
1955-14.5-7.7-5.3-12.4-10.1-1.1
1973-16.6-27.2-20.5-8.726.82.4
1974-27.210.938.317.373.35.7
1994-12.214.538.25699.37.1
Real total returns from JST Macrohistory. February 2023. 

Real total returns from JST Macrohistory. February 2023

Here, we see that the worst one-year bond losses aren’t much gentler than the worst stock market losses. But the rebound can be even more arduous, with 50% of sample periods still in the red at the five-year mark.

What can we learn from all of this data? Well, it suggests that staying invested is usually the best approach. While the worst equity crashes aren’t predictive of more slaughter to come, they often provide opportunities to buy stocks at a discount. And while it may take some time, the market should eventually right itself.

However, it’s important to remember that patience is key. Markets can take longer to recover than we might expect, and it’s essential to have a long-term perspective. So, keep your head together after a bad run and don’t chase the market. Give it time, and it should turn in your favor. Remember, sooner or later, your patience will likely be rewarded.

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