Fear and Santa

‘Twas the eve before Christmas and not a Santa rally in sight. Year-to-date the S&P 500 is on the cusp of a bear market, closing down -19.78% from its all-time high of 2,930.75 in September.

The sell-off began in October and has been swift and fierce, summoning flashbacks of the S&P 500’s harrowing drawdown of more than 56% during the financial crisis. The palpable anxiety and barrage of negative headlines have many convinced this is the start of the next major market crash.

In times like these, it’s useful to separate yourself from the crowd’s hysteria, to take a step back and a good look at the bigger picture. First, let’s state the obvious. The stock market is volatile, it’s supposed to be. Volatility is part of the normal ebbs and flows of a properly functioning market.

Chart 1 below shows the annualized volatility for the S&P 500 for the past five decades (as measured by standard deviation). Note that over long periods (decades shown in blue), volatility has been fairly consistent, averaging between 16% to 17% per year. This is a widely recognized statistic. So far, in 2018, stock market volatility has registered a read of 16.69% (in red). Not only is this not extreme it’s actually very normal.

Chart 1

Source: Robert Shiller Online Data, Yahoo Finance, BCM

But still, it sure doesn’t feel like normal. Well, it never does, and every pullback can feel like the next big one. But I think there are a few reasons why the current sell-off feels especially acute.

First, in Chart 1, notice 2017 was actually the anomaly (in grey). Volatility was extremely low and came in at just 6.26%.

Second, 2017 was the first “perfect year” in US stock market history, going up every single month of the calendar year.

Third, before 2018 US stocks went almost two years without even a 10% correction, also abnormal.

Fourth, let’s not forget the stock market is on a tremendous, decade-long run that is arguably the longest in US history.

With these lopsided reference points as our closest anchors, is it possible that investors were complacent and expected markets to only go up? Yes, I think that’s very possible.

It’s also possible we cascade into the largest drawdown ever, but I think unlikely. As I’ve been writing throughout the year, this sell-off appears technical and driven by sentiment. Deep and prolonged crashes are typically driven by fundamentals, which by and large still look positive.

Unless we see some real deterioration in things like growth, corporate earnings, and interest rates, then nervousness, anxiety, and selling pressure will fade as the market realizes there is nothing to fear but fear itself. I’ll elaborate on this topic further in our upcoming annual letter.

But for now, remember to focus on the bigger picture. Not just on the economy and the long-term, but on the biggest things we have to be grateful for during the Holidays. Family, friends, and the many blessings we can count even if Santa doesn’t show up.

At BCM, that includes all of our clients. Thank you for your continued support and always keeping us in mind as a resource for you, your family, and friends. It is your vote of confidence that keeps us striving to always do better. Happy Holidays to you and I look forward to connecting with you in the New Year.

Victor K. Lai, CFA