Rational Advisor

“Many an optimist has become rich by buying out a pessimist” - Robert Allan

I know, the comment usually comes to these are uncharted times; no one has seen anything like this before.

True, but every crisis is unique. In the case of this event, we have never seen such a decline in house prices and have never seen such a policy response either. The US market downturn is approximately -52% and the average decline in the last 11 bear markets (spanning 70 years) is about -32%. In the 1970s we saw a decline of -48%, and the bursting of the tech stock bubble took markets down -49%, each of these had unique drivers as well.

Selling equities after they are at a near 10-year low and buying them back later is a sure way to lock in losses and minimize participation in a rally. This is only the third time since the crash of 1987, what happened after investors en-mass withdrew to cash, in 1987, a 12-year bull market. When was the next time? 2002. What happened after that? a 5-year bull market. This is the third time. And the past may repeat itself.

Truly extraordinary years (up and down) are by definition hard to predict. However, they do happen, and history provides us some lessons. Let’s look at recent major rallies (we’ll use the DJIA because it has the history):

1. 1933 +57% - Franklin Roosevelt re-flated the economy and stocks moved up sharply after the great Depression sell-off

2. 1935 +47% - Confidence returned to the banking system, credit lending returned and the auto sector led the market higher.

3. 1954 +52% - A shift from the US Federal Reserve to easing (after an inflation scare) to avoid fears of another depression altered expectations in the markets.

4. 1958 +43% - Corporate Confidence fell after the Soviet Union successfully launched the world’s first satellite, Sputnik, but the combination of heavy federal spending and the US Federal Reserve moderating rates drove institutional investors back into stocks.

5. 1975 +37% - Stocks rallied after reaching a post-1929 low in P/E when a sharp rise in bank failures caused the Fed to ease credit sharply, following the collapse of the Bretton Woods system and the 1973 oil crisis.

6. 1995 +36% - Chairman Greenspan’s abrupt tightening in 1994 depressed equity markets and 1995 was a rebound rally, with shares soaring as Japan cut rates and led global re-liquefaction

In reviewing these we do see a pattern - Bounce Back from a drop and Easing of Credit does help.

Bounce Backs

It’s clear that when the world seems to be coming to an end and markets fall sharply, large recoveries do happen. Most of them were not expected by the pessimists of the day.

- The 1908 boom (+45%) followed the panic of 1907
- The Great Crash of 1929 was followed by the largest rally of the century in 1933 (+53%) and was followed by the fourth largest rally in 1935 (+47%)
- In 1954 (+52%) a rally followed a -11% decline in 1953 as capacity utilization and consumer spending fell at such a rate that the fear of depression gripped the markets.
- In 1958 (+43%), was preceded by 1 -13% decline of the Dow in 1957
- In 1975 (+37%), after fears of recession, inflation and disastrous governmental action drove P/Es to their lowest since 1929

Easing of Credit is another common theme that helped foster large rallies.

- The end of the “Panic of 1907” would not have led to the boom in 1908, is JP Morgan has not stopped the US banking crisis
- Expansion of bank credit was key to the boom of 1935
- The mid-year 1954 easing was key to that year’s performance, while the Federal Reserve unexpectedly reversed its course to an easing in late 1957 helped produce the 1958 rally, which was fuelled by further rate cuts throughout the year.
- As recently as 1995, The Greenspan Federal Reserve surprised markets by reversing a previous tightening bias and easing as a result of the Mexican financial crisis.

The pattern from these major rallies in history is clear. Rallies start from stocks in depressed levels, and a sudden exogenous event puts fears of inflation on the back burners of the Feds. As they help re-liquify the stock markets with cash.

The once consistency we have to large rallies in the stock markets since 1900 in all but one case (1928) is the combination of depressed prices and an easing of credit availability.

From the Long Term Capital Management/Asian Contagion meltdown in 1998 to the war/recession/layoffs/savings & loan crisis of 1990-91 to the greatest one-day stock market crash of all time in 1987. One thing has remained constant the markets have recovered strongly from all of these. I don’t know how it’s going to end, but I’m confident that it is going to end.

It’s also true that in every case pessimistic forecasts based on drops in the markets have repeatedly proven to be an expensive error. At the start of every strong year, the press is almost universally negative and almost universally wrong.

We’ve found the best tool in a chaotic environment has been a solid framework for making decisions. When least expected a spark may touch off the greatest buying panic any of us has ever seen.