What Does a 500 Point Drop Tell Us About the Future?

Sean Insights

The Dow Jones Industrial Average closed down 513 points today, a one-day loss of 4.31%. Interestingly enough, two economic news headlines, both from Reuters, remained up on Yahoo! Finance all day:

Jobs, Retail Sales Data Support Recovery Hopes, with the lead paragraph reading: “The number of Americans claiming new unemployment benefits was steady last week and heavy discounting lifted sales at retailers in July, hopeful signs for the sputtering economy.”

And in a separate story, we had this:

“General Motors quarterly profit shot past Wall Street expectations, but its share price slipped as investors focused on the risks of a sputtering economy and resurgent Japanese rivals. GM reported second-quarter profit that nearly doubled as people paid more for new cars like the Chevrolet Cruze, and the automaker took a larger share of global sales as major Japanese competitors were largely sidelined by the March earthquake.”

Of course, along with these mildly encouraging headlines, were these much scarier headlines:

From the AP:

Dow Falls 512 in Steepest Decline Since ’08 Crisis

And CNBC offered these ominous stories:

World Stocks Plunge

Stocks Critical: Brace for More Selling

Investor Survey: Worst Pessimism Since May 2010   (My comment: Nevermind that the Dow would finish up 2010 14% above where it was when this headline was published)

As we now sit after today’s market close, US markets have fallen just under 10% in the last three months (although closer to 11% if we go back to April 29th of this year, the year-to-date high water mark). So, how common are 10% pullbacks? About as common as dirt. Since 1950, the US market has seen more than 30 such market corrections. This means that, on average, pullbacks of 10% or more occur about one out of every two years. (When I think of panicking out at a 10% market correction, the thought of panicking at news of a solar eclipse also comes to mind, and despite concerns that the world – financial or otherwise – may end, neither a solar eclipse nor a 10% market correction tells us much about what lies ahead, as I’ll discuss below.)

Having just downloaded the entire Dow Jones Industrial Average daily closing price data series, I spent this afternoon trolling through that data in Excel, and thought a bit of data analysis / statistical history might provide some hopefully worthwhile perspective on today’s market performance, and the last three months’ dip.

By way of comparison, today’s drop of 4.31% didn’t crack the top 10 one-day market drops, percentage-wise, and for that matter, didn’t even make the top 100 (it ranks #106, to be exact). The largest one-day market drop occurred on October 19th, 1987 (“Black Monday”) and saw the Dow Jones drop a whopping 22.61% in one day. That’s a drop about five times larger than the one we saw today, and for what it’s worth, the US market produced positive returns the next day, next week, as well as the next six months and twelve months, following this worst day ever, and only mildly negative returns in the subsequent one and three month periods.

Perhaps of greater interest is what such a drop as we’ve just seen might tell us about future stock market returns over the coming days, weeks and months. Unfortunately, the answer is, “not much.”

The table below shows what the likelihood is of having a positive return following one of the worst 10 days in market history, or one of the worst 105 days in market history, or following a three-month market correction of 10%. Keep in mind that all of the drops were as bad or worse than the one we saw today or have seen in the last three months.

So, just to be clear about what the table above is illustrating, here’s an example. If we look at the first box under 1-Day Drop of 7.87% or More (A Top 10 Worst One-Day Market day), on the Next Day line, the 70% figure is telling us that in 7 out of the top 10 worst market days ever, the next day’s market return was positive, and if we look at the Next 12 Months line under that same column, it’s telling us that in 50% of the following 12 month periods, the market also produced positive returns.

As you can see, in 15 out of 18 boxes, ranging from one-day to one-year periods following major market movements, the ensuing results were positive. The best number on the page is the 63% (bottom-most, right-most corner), which indicates that in 63% of the cases where the market dropped 10% or more in a three month window, the ensuing 12 month market returns were positive.

None of this is to minimize the economic risks that lay ahead, which may be very real. However, it is worth remembering that in all of the negative market events represented on the table, there were almost certainly news headlines as dire and as worrisome as the news we see in today’s headlines, because without such news, it is unlikely that those historical markets would have been as sharply negative as they were – and yet, despite whatever those dire headlines and economic worries were, in more than half of the cases, markets produced positive – and sometimes staggeringly positive – returns in the days, weeks, and months that followed.

This, of course, is not to say that markets can’t or won’t trend downward. What this is to say, however, is that the market’s past performance – whether it be a substantial one-day drop as we’ve just seen, or a three-month 10% correction, as we’ve also just seen – tells us almost nothing about the market’s likely performance in the ensuing days, weeks and months ahead.