The Rubber Band Effect

The stock market doesn’t go straight up.  Profound, right?!  It does have an upward bias, however.  Meaning, it goes up most of the time.  However, those times when it’s going down, it happens in typically one of three ways:

 

  • Most frequently (roughly 3 times-per-year), the market pulls back by about -5%
  • Less frequently (roughly once-per-year), the market corrects to the tune of -13%
  • While rare (roughly once every seven years), bear markets produce losses of -42% on average

 

Now that you understand what to expect and what’s “normal,” let’s talk specifically about market pull-backs (drops of -5% on average).  What you also need to know is that these pull-backs usually take place over the course of 45 days.  They can start and end on any day of the month as well, which means that for the most part, investors don’t even realize they’ve happened until they’re in the rear-view mirror.

 

The month of May was pretty unique, however.  The market peaked, hitting all-time-highs on April 30th, then the market fell -7.6% on an intra-day basis from May 1st through May 31st, literally bottoming on the last day of the month!

 

What’s unique about that?  Again, the average pullback is -5% and it happens roughly three times-per-year, right?  What is so unique and interesting about May is that it went down about 50% more than the “normal” pullback, and it did it in exactly 31 calendar days.

 

Why is this important?  It might not be obvious – but the answer is: “Investor Psychology.”

 

Think about it.  When do your statements get printed?  The end of the month, right?  What time period does the statement represent?  The previous month’s performance…

 

So when investors looked at their May statements, the pullback didn’t take place over two statement cycles with a little drop in market value.  No… the market pulled back, all within 31 days, creating a situation where investors just happen to see, on paper, a pretty big, but normal market pullback, but it doesn’t FEEL normal when it goes down that much, that fast, does it?!

 

Now, for any investor who looked at their statement for the month of may, it wouldn’t be out of the question to see their retirement portfolio down -7.6% (or more) if they’re invested in 100% stocks.  However, if they would’ve logged into their account just five days later, they would see that the market had screamed northward by 6.7% in only a week!

 

The market is like a rubber band.  If it moves too far, too fast in one direction or the other, it tends to snap back with similar velocity in the opposite direction.  There are different time frames for these snap-backs, of course.

 

For instance, this most recent pullback of -7.6% in one month resulted in a big, quick snap-back of +6.7% in a quarter of the time.  On the other hand, the market fell almost -20% in three months during the 4th quarter of 2018 and then the market screamed northward to the tune of +20% in half as much time.

 

Taking things one step further, the historic bull market between 1987 – 2000 produced huge gains over a long period of time, but it’s still a rubber band… just a bigger, slower, longer one, and when it snapped, -47% of the wealth accumulated in the S&P500 at the time was vaporized in 24 months.

 

Point being, it took a long time (2 years) for that slow-motion train-wreck to unfold, but it was still the rubber band effect at play here.  This bull market we’re living in today, which is arguably in its 10th year, remains the 2nd longest in history, second only to the 1987 – 2000 dot-com bubble mentioned above.  It, too, will have its own snap-back someday, and it’ll probably be slow (averaging 18 months or so in length), so we just need to be prepared and paying attention!

 

Right now, the market looks pretty good to me.  This past week, the S&P500 is pretty much in the same place it was 18 months ago.  It’s been a pretty wild ride since January of 2018 with three substantial drops in market value in a short period of time including a:

 

  • -10% correction in January ‘18
  • -8% correction in March ‘18
  • -20% correction between September and December of ’18, and
  • The most recent -7.6% pullback this past month

 

Since March, however, the risks of an imminent market crash have declined substantially.  More and more stocks within the major market indices are hitting new highs, momentum is in a positive range, and you can see in the chart below that the S&P500 is printing new successive highs over time, which is positive evidence that I find very encouraging.

 

The chart concept below has become a client favorite this year, as the different “zones” represent the amount of risk I believe is present in each range…

 

Right now, we’re teetering on the edge of the “all systems go” and “caution” zones, and that doesn’t give me much worry.  In fact, with the ridiculously fast, +6.7% move in the market last week, this week’s market action hasn’t surprised me, nor would it be shocking to see the market consolidate and fall a little into the “caution” area next week as it digests those quick gains.

 

Another positive piece of evidence is the fact that the May pull-back has resulted in an intermediate-term higher-low, which is also good, normal, and healthy market action.  Going forward, I’d like to see the market trade down or sideways this next couple weeks, but then find itself back in the “green zone,” then to new, all-time-highs, and at that point, we could be moving on to experience some pretty fun times for the first time in a long while!

 

In the meantime, enjoy the beautiful weather today, and I want to wish all my fellow dads a happy Father’s Day.  Spend some intentional, high-quality time with your kids, reminisce and think back through the years, give them lots of hugs, and use this special weekend to remember how wonderful they are – and how much fulfillment they add to our lives!

 

Till next time…

Adam

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