Thoughts on the Flash Crash and Current Market Volatility
2010 - June - Category: Other Print This Article

On Thursday, May 6th at about 2:30 PM, the Dow Jones Industrial Average fell nearly 1,000 points in about 16 minutes.  Then it bounced back almost as fast and recovered most of the losses.  There have been many explanations offered as to the cause of the “flash crash” but no definite conclusions. 

Congress will surely conduct investigations and hold hearings.  Meanwhile, some commentators have concluded it was some sort of technical glitch and others, including the New York Times, have attributed it to “algorithmic trading strategies” (a technical term for “we don’t have a clue”).  The consensus among the financial media is that it must have been caused by the Greek Credit Crisis, simply because it was the major headline that week. 

To put this into perspective, the Greek economy is only about the size of Los Angeles County, its sovereign debt has been in default for 105 out of the last 200 years, and they have been bailed out before.  So why is everyone suddenly so worried about the situation in Greece?  The answer, of course, must be what it represents: contagion to the rest of Europe and the beginning of the next “end of the world” crisis.  It represents the possibility that the economic recovery may not hold, that instead of the hoped for “V-shaped” recovery, it’s the dreaded “W-shaped” recovery and the “double-dip recession”.  In other words, the world may end after all. 

More important than the question of "what happened?" is "what did you do about it?"  Did you panic and sell, abandoning your long-term plan?  Or did you focus on the long-term objectives of your financial plan such as making sure you have sufficient financial resources to maintain the lifestyle you desire during many years of retirement? 

Consider that a typical married couple at the average age of retirement, currently 62, has a joint life expectancy of 92.  As such, a typical couple’s retirement plan must provide for a 30-year investment time horizon or more, during which the spouses will need to generate sufficient returns on their investments in order to avoid outliving them.  Investing in fixed income alone will not enable most people to finance their retirements, which is why most investment portfolios should include an allocation to equities.  For most investors, the greatest obstacle to achieving investment success is not the performance of the financial markets, but their own tendency to panic in reaction to the crisis of the day and abandon their plan. 

In the past 30 years we have had six bear markets (defined as a 20% decline in the value of equities), each connected with a major geopolitical or financial crisis (i.e., an average of about one every five years, not counting the many minor crises in between).  This includes the greatest one-day drop in the history of the U.S. stock market of 23% on October 19, 1987* (“Black Monday”) and the two worst declines since the Great Depression (the “Tech bubble” of 2000-2002 and the “Great Recession” of 2007-2009).  Through May and June 2010, the Dow has declined to around 10,000 after rallying to over 12,000 in April.  Where was the Dow at the beginning of this 30 year period? At the end of May 1980 it closed at 850.84. 

Going back further, there have been 13 major bear markets (defined as 30% declines in the value of equities) since the end of World War II (again about once every 5 years), each in reaction to a major crisis somewhere in the world.  Each of these events was as devastating and threatening as any of the recent episodes, but they were all resolved and are now just statistics.  The next crisis we will face will always seem scarier than those of the past because the thought will inevitably come up that maybe “this time it’s different.”  It will almost certainly be different and feel like the world may be coming to an end.  Despite all the turmoil since the end of World War II, the S&P 500 has generated compounded annualized returns of 11% through the end of 2009.  

What does any of this prove about the future?  Probably nothing, but I would venture to say that anyone who panicked and got out of the market during any of the many “end of the world” market declines or the mini-crises in between probably regrets having done so. 

During these periods, equity markets have also tended to decline 10% or more about once a year, usually in relation to a mini or major crisis.  The current market decline since April is, so far, of the 10% average annual variety.  There is no way to know whether it will turn into another bear market of 20% or more.  We have learned from history, however, that if you sell every time stocks decline 10% thinking we are heading for a bear market, you will probably be wrong 80% of the time. Recall that the 20% declines occur every 5 years on the average. 

In conclusion, crises such as the current one appear to be the norm rather than the exception.**  Stocks are always risky, which is why investors should expect higher returns versus fixed income.  Over the long run, the real return on stocks has been 2.5 times that of bonds.  Investors should continue to expect higher returns from stocks, but there are no guarantees that they will materialize, especially in the short term.  This is why our advice is always to take no more risk than an investor has the need, willingness, and ability to take.

The best course of action for the long-term prudent investor is to adhere to his or her well thought out financial plan and view these market declines as an opportunity to rebalance one’s portfolio.  In down markets, the rebalancing discipline creates an opportunity to buy equities when prices are lower.  Whether your investment time horizon is 20 years, 30 years, or more, the current “crisis du jour” is not worth worrying about.  Your best strategy is to turn off the television, stop looking at the real time ticker of the market averages and get out of the habit of looking up the value of your portfolio on a daily basis.  What happens in the markets today is largely irrelevant as long as you don’t make the fatal mistake of abandoning your plan. 

* Interestingly, the Dow Jones Industrial Average was positive for the calendar year 1987 after dropping 508 points and closing at 1,739 on October 19th.

** Larry Swedore has written an excellent article titled “Lessons Learned from the Greek Tragedy” for his blog on CBS Moneywatch listing some of the major crises in recent years.  Click here for a link to the article. 

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