Mind-Bending Markets Play “Red Light/Green Light”

By David Geller   |   February 7, 2018

sp-500-index-market-volatility/

On Monday, February 5th, the S&P 500 Index and Dow Jones Industrial Average (DJIA) both fell more than 4%, marking the worst one-day percentage decline since August 2011. When combined with declines from last Friday, the last two trading sessions resulted in these indices falling more than 6%, bringing the indices back to levels as of mid-December 2017.

Remarkably, the recent sell-off ends a streak of more than 400 trading sessions since the last time the S&P 500 Index had experienced a 5% pullback (dating back to the Brexit vote of June 2016).

S&P 500 Index Volatility Feb 2018

What Caused the Pullback?

There was no notable development or headline that led to the recent market pullback. In fact, corporate earnings and global economic data generally have remained quite strong. Some have pointed to concerns over a pick-up in inflation, rising bond yields and waning central bank stimulus as potential factors behind the volatility.

Other possible factors:

  1. Stop-loss orders, which would have automatically triggered sales during the sharp intraday decline
  2. Algorithmic trading: computer models which recognize the pace of the decline and in turn produce additional selling – a situation of “selling begets more selling”

The best answer is that no one knows what caused the sell-off. Those explanations are just supposition, not fact. Clicking news headlines in an effort to be a more informed investor (that’s our information bias at work) can have serious potential drawbacks. It can play into our brain’s penchant for spotting patterns even where there are none to be found. (One example of the clustering illusion: The roulette wheel doesn’t favor red even though we’ve watched the ball land on red 73 of the last 100 times.)

Our advice: Investors need to be vigilant consumers of sensational media and savvy about behavioral biases that can lead us to make unwise decisions based on these faulty causal connections.

Is the Recent Market Move Unprecedented?

No. It’s important to note that while the recent pullback has been sharp over a short period of time, the move is well within historical norms. Many news media sensationalized the market pullback by focusing on the fact that the DJIA recorded its biggest single-day point decline (-1,175) even though the percentage decline (-4.6%) was only its 100th worst single trading day, according to S&P Dow Jones Indices.

Since 2017 was such a unique, extended period of low volatility, the recent market pullback feels extreme. Last year, the S&P 500 Index’s maximum peak-to-trough drawdown was only -3%; since 1928, the index’s average intra-year decline is nearly -14%. The S&P 500 Index didn’t drop more than 2% on a single trading day last year. However, it DID decline on 5 days in 2016, 6 days in 2015, 4 days in 2014, and 21 days in 2011. That’s unusually smooth sailing.

Frequency of Market Pullbacks (S&P 500 Index, 1928-2015)

SP 500 Index market volatility - SP 500 index drawdowns

Source Standard & Poor’s, FactSet, J.P. Morgan Asset Management (“Investing with Composure in Volatile Markets”)

WHAT SHOULD INVESTORS DO?

We’ve had an amazing run, and it isn’t uncommon for the markets to take a breather after such spectacular results. Market corrections are an expected and necessary part of investing.

“The Stock Market Didn’t Get Tested—You Did,” cautions Jason Zweig, writer of the Intelligent Investor in the Wall Street Journal and author of Your Money and Your Brain. While it’s understandable for investors to feel frustrated or anxious in the midst of such market volatility, it’s essential to maintain a longer-term view. In all likelihood, you have the same time horizon today as you did a week ago.

As Zweig explains, there’s another behavioral bias that investors should keep in mind during this market volatility. “The abnormal smoothness of the stock market over the past couple of years set investors up for a shock whenever stocks did fall at least 5%, as they did on Monday,” he wrote.

The recency bias leads us to believe that stocks will continue to rise in a straight line as it has in the last two years. So when the market defies our expectations of a smooth ride, we might panic and abandon our investment strategy.

During periods of heightened volatility, investors often feel the need to “DO SOMETHING,” even though short-term, reactive moves are often ill-timed. More importantly, those moves can significantly impair the effectiveness of a well-designed investment plan.

February 6: Dow Closes Up +2.3%

February 6 demonstrated the futility of reacting to short-term market moves. The market changed direction an astonishing 29 times before the Dow ultimately closed up 567 points (2.3%) at the close. 

To counter “the sky is falling!” reaction, we can remind ourselves to expect market volatility. By understanding how markets have historically worked, we can normalize corrections like those we experienced this week. That long-term perspective can calm us, reinforce our faith that “it’s not different this time,” and help us stick with our long-term investment strategy.

If you have any questions, please contact your JOYN Advisor.


RELATED STORY: 2017 Tax Bill Highlights & Year-End Planning Opportunities

David Geller

About the Author

CEO David Geller co-founded the firm in 1991 and led the creation of Behavioral Wealth Management. Recognized on numerous prestigious "top financial advisor" lists, David is an in-demand speaker for professional groups and JOYN workshops. His writings have appeared in The New York Times, The Wall Street Journal and The Huffington Post.

Read More By David Geller >>

Join Us

When wealth advisors look and sound the same, how do you choose? A coin flip? Pick your neighbor? Why leave such an important decision to chance? Instead, join us at an upcoming workshop. Hear recent research, discover new insights, and experience JOYN’s transparency and expertise firsthand.

Get In Touch