Some of you have probably heard the saying “Bear markets make people a lot of money, they just don’t know it at the time”. This morning, Meb Faber is out with some interesting observations that confirm the same notion. What is the 3-year return of different asset classes after they have crashed:
Average 3 year nominal returns when buying a sector down since 1920s:
down 60% = 57% recovery
down 70% = 87% recovery
down 80% = 172% recovery
down 90% = 240% recovery
Should this data encourage you to hold forever to your losers and remain fully invested in any market environment? No, let’s take a quick look why:
If an asset drops 90%, let’s say from $100 to $10; then a 240% gain will bring it back to $34, which is still 66% below the starting price. Not a big consolation, right?
We all know that momentum works best in a 3 to 18 months time frame and anything beyond 3 years, usually leads to mean-reversion. Sooner or later all uptrends and downtrends end. Some downtrends end with bankruptcy.
Any asset that is down 90% is probably priced for bankruptcy in some way or another. Of course, if the perceptions turn out to be much worse than the reality and that asset survives, it will rally big time and be among the best performers during the recovery process. We all saw the massive 1000%+ returns from the 2009 bottom in some of the cyclical stocks – truckers and furniture stores. Buying a basket of small cap stocks after big market crashes has worked flawlessly in the U.S. over time.
The big question is – do you buy blindly, any time an asset is down 80%? What if it gets to a point being down 90% from its original price? A move to being down 90% after being down 80% is a another 50% loss. (From $100 to $20 to $10). There have been numerous bottom hunters in the coal industry over the past couple years, only to find out that there is a hole in the bottom later. What if an asset that is down 90% gets to a point where it is down 99%. It happened in Cyprus.
To take advantage of such massive crashes, you have to keep your powder dry. You need to protect your capital in signs of weakness and actually cut your losers when their trends get broken.
There is a way to use market crashes to your advantage, but it is not by buying blindly anything that is down 80%. I will talk about it in another post.