Two States

This was written before yesterday’s selloff in the global markets.  The premise still holds true, except the decline is larger now.  

Two States

A portfolio can only be in two states:  a drawdown or making new highs.   The definition of a drawdown is the decline from a peak value (new highs) to a trough (the low).  Technically, a drawdown is not over until we make a new high.  For our purposes,  I will illustrate what a drawdown is in % terms.  We can also look at how many days it takes to get back to an all-time high.

How does this look in the real world?  Well, last week was a bad week for all asset classes, not just US stocks, but for now, we will just look at the SPDR S&P 500 ETF (ticker: “SPY”).  The price of the SPY closed at 286 (rounding) on 01/26/2018 which was five trading days ago.    Last week’s selloff brought the SPY down by 3.88% to 275.  So, the SPY is currently in a drawdown of 3.88%.  Was 01/26/2018 the top?  Well, history suggests that it could be, at least for awhile, which I attempt to explain below.

I took a look at the past peformance for SPY going back to its inception date.  The SPY started trading on 01/22/1993 (note: the SPY recently celebrated its 25th anniversary).  If you had the foresight to put all your eggs in this ETF basket, your total return would have been 903.7% through Friday’s close.  Impressive performance.  Oh to go back in time!

There were 6,758 trading days since 01/22/1993, and there were 457 new highs made throughout that time, 586 when you include the return from dividends.  When you divide 457 by 6,758 trading days, it comes out to 7.25% which means that the SPY (again a proxy for the S&P 500 index) was making new highs 7.25% of the time.  Conversely, this means that the other 92.75% of the time the SPY was in a drawdown.  Let me repeat this in another way.  If you are looking at daily returns, then a majority of the time, your stock portfolio will be below its highest value.  

The chart below shows the % off the high for the SPY since its inception date.  Everyone is well aware of the two massive drawdowns that happened between 2000 to 2010.  The y-axis shows how much the drop was in % terms.

% OFF THE HIGH

2017 

I have previously written how 2017 was an above average year from a return standpoint.  On a total return basis (price return + dividends), the SPY recorded 61 new highs.  There were 251 trading days in 2017 which means 24.3% of the time; the SPY was not in a drawdown.  Wow!  Comparing last years 24.3% to the historical average of 7.25% for SPY, you can see why investors were expecting a pullback of some magnitude.

In the chart below, I zoomed in on the % off the high for the dates between Jan 2017 and to the close on Friday, February 2.

% off the high 2017

A couple of things of note: (1) the SPY did not have a pullback 3.0% in all of 2017 and (2) since the small pullback in August 2017; the SPY barely went down until last week.

2018

January had 21 trading days.  Of those 21 days, the SPY made 14 new highs.  We made the 14th high on 01/26/2018 and then:

SPY - YTD through 02.2.2018

Was it the top?

It could be the top of the market for 2018.  It could be the top of the market for the next five years.  At this point, we do not know, and we will only know until we make new highs.  Moreover, this angst or uncertainty does not go away either.  Let’s say in the next week or two, the SPY makes a new all-time high, and then another selloff happens.  Will that be the top?  Rinse and repeat the same discussion.

If you are having trouble dealing with this selloff, its essential go back to the basics.  What is your investment objective?  What are your constraints to reaching your goals, such as risk tolerance, time horizon,  and short-term cash needs?

A couple of questions to ask yourself at this time:

(1).  Do I have to withdraw money from my investments in stocks, long-term bonds, real estate, or Private Equity in the next five years to seven years?  If so, how much?

(2).  Do I have enough money in cash, money markets, short-term bonds to get me through a prolong portfolio drawdown?

(3).  Did you have a financial plan that takes into consideration your withdrawal rates on your portfolio?

(4).  How much of my assets are outside the stock market?

(5).  What happens if my investments lost 20% of the value and it does not regain its value for ten years?

In summary, we know markets go up and down.  We cannot control what happens on a  daily basis.  Focusing on the long-term is underrated when short-term craziness is occurring between 9:30 am and 4:00 pm every day.