Not for the faint-hearted: Wild, potentially lucrative stock market ‘snap-backs’ – The Mercury News

One of my favorite New Yorker cartoons depicted a fortune teller looking into a crystal ball. To her customer, beside whom a Labrador retriever sat with a baleful look, the woman predicted, “I see a 10-foot retractable leash in your future.” Similarly, it calls to mind a mental image of our stock market, which could be approaching the end of its leash.

Market tops often end with a last-minute upward burst — like a dog on a retractable leash, leaping at a squirrel — before starting another periodic plunge. So, this is a time to review some history of market downdrafts, corrections and what I would call “snap-backs.”

I have mentioned in the past that the six major crashes since the ’73-’74 crash have been followed by an average 39 percent rise in the 12-month period starting with the day the market hit bottom. Twenty percent happened within the first eight weeks. The second 12 months saw an average increase of 11 percent. Those are just averages. The greater the downdraft, the more the snap-back.

Going back just 50 years may not be convincing enough to reassure some people, so some data in a recent issue of AAII Journal lay out the history of crashes and recoveries since World War II. They define “pullbacks” as declines of 5 percent to 10 percent. A “correction” is 10 percent to 20 percent. A “garden variety bear market” is from 20 percent to 39.9 percent, and a “mega meltdown” is something greater than 40 percent.

That said, we’ve had 56 pullbacks, lasting one month and requiring an average of two months to recover.

We’ve had 21 corrections, lasting five months and recovering in four.

We’ve had eight lesser bear markets lasting 11 months, which took 14 months to recover.

And finally, the three major meltdowns, averaging losses of 51 percent, lasted 23 months while recovering over 58 months.

What these statistics don’t tell us is the extent to which diversification across different investment types can reduce the volatility. We know that statistics based on the S&P 500 reflect a reasonable picture of U.S. stock market performance, but the S&P’s performance can be weighted periodically by one industry or another.

At various times, someone with all of their eggs in the S&P 500 basket could find themselves with a third of their money in technology (1999) or financial services (2008) because some industry sectors enjoy stock performance that tilts what is supposed to be a broad cross section of the economy. Usually those periods are temporary and prove to be the product of that shark feeding frenzy of irrational exuberance. We’re approaching it now with tech stocks representing close to 20 percent of total stock market value.

So, one way to mitigate the effects of a downdraft is to spread money out over different asset classes. We remain in the game, but reduce volatility. For example, while the S&P 500 was even for the 10-year “lost decade” ending in 2009, a combination of small-cap stocks, emerging markets and other asset classes typically earned an average of about 6 percent collectively during the same period. Emerging markets alone were up 40 percent in 2007 and 83 percent in 2009. A portion in real estate investment trust funds also helped out.

The mistake is to assume that the market is now overpriced and that it’s time to sit on the sidelines in a money market fund losing 2 percent per year to inflation. Hoping to get back in when you’re sure the market has hit the bottom is like trying to catch a falling knife. If you think you might just defy the odds, good luck with that.

The market is like a dog on a leash. It yanks us around, but we make steady progress as we take what can be a “random walk down Wall Street.”

But while a dog’s love is unconditional, the market requires that we stay with it. As Warren Buffett says, his favorite holding period for a stock is, “forever.”

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