Studying Drawdowns To Manage Expectations For Market Corrections

By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com

The recent sell-off in the US stock market was, as usual, greeted by many in the press with headlines of doom and gloom. But measured against the historical record, the current peak-to-trough decline for the S&P 500 Index still ranks as a relatively common event.

As of mid-afternoon trading on Tuesday, August 6, the S&P 500 drawdown is -6.9%. Since 1950, there have been 45 drawdowns between -5% and -10% based on analysis by TMC Research. That seems to imply that a drawdown in that range will arrive once within every 1-1/2 year time window.

The events that trigger drawdowns – declines in the market from a previous peak – are generally random and so they can be triggered by any number of catalysts. Predicting significant drawdowns -- deeper than -10% -- is, unfortunately, devilishly difficult if not impossible. History, however, reminds that investors should be prepared for periodic drawdowns of some significance in the same way that residents along the eastern seaboard of the US should be ready for hurricanes.

In contrast with stocking up on food and water to ride out tropical storms, best practices for investors preparing for relatively steep drawdowns starts with managing expectations to prevent behavioral risk from triggering ill-timed decisions. A key part of that prep is understanding the history of drawdowns and factoring that into asset allocation strategies.

One way to start is by recognizing that truly steep peak-to-trough declines are a rare bird. Since 1950, for example, there have been only 11 drawdowns that exceeded a 20% slide (see table). The deepest drawdown in the last seven decades-plus was a monster loss of nearly 57% from the peak that unfolded over 2007-2013 when including the recovery. Fortunately, most declines fall well short of that outlier in both time and loss.

Another way to analyze drawdowns in an effort to manage expectations is reviewing the length of the recoveries relative to the deepest point of the decline. The average recovery of the drawdowns in the table above: roughly 515 trading days, or about two years. The lion’s share of recoveries for the 100-deepest drawdowns since 1950 fall within a fairly speedy range of 13 to 59 trading days, based on the interquartile range (i.e., the 25th to 75th percentiles).

Visualizing the history of recoveries vs. the depth of the 100-deepest drawdowns since 1950 also reminds that markets usually tend to rebound to previous peaks in relatively short order (see chart below).

To the extent that drawdowns are top of mind for the average investor, the focus is on the worst offenders. Fortunately, such events are the exception to the rule. But it’s also true that every steep peak-to-trough decline starts as a mild drawdown and deteriorates from there. Yet most drawdowns also turn out to be mild affairs, a.k.a. noise in the routine ebb and flow of markets.

Determining in real time if a garden-variety drawdown will deteriorate into an unusually steep decline generally requires looking to broad economic and financial conditions for assessing the risk outlook. On the basis, the jury’s still out as to whether the current drawdown will deteriorate into a steep loss or remain a comparatively mild correction. A key factor that will likely play a role in determining the outcome in the weeks ahead is the US economy, namely: Will it slip into recession? For now, the jury’s still out, although TMC Research’s macro analytics are currently leaning toward the soft-economic landing scenario.