The year 2008 will be remembered as one of the worst years in stock market history. In fact, it was the second worst year since the New York exchange was created in 1825 (see Figure below).
With consumer and investor confidence near all-time lows, it is no surprise that Wall Street analysts expect a poor earnings season. Overall, analysts expect a 37% decline in profits. Moreover, interviews with financial historians, market strategists, and efficient market economists, point mostly to painful scenarios. Forecasters also agree that the market turmoil could continue for months or even years, and their consensus is to “stay on the sidelines”. On the opposite extreme, Warren Buffett has often advised to “be fearful when others are greedy, and be greedy when others are fearful”. So what should the intelligent investor do? Buy on momentum, when everything seems to be going up, or to be a contrarian by buying when everything is going down? We have analyzed stock market returns since 1871, and we believe we have an answer, and the results are somewhat surprising.
Our analysis indicates that the ten worst stock market drops average - 26.4%, whereas the ten best rallies average +46.3%. This is an indication that bull markets tend to be prolonged by optimistic overconfidence, or “irrational exuberance” as Alan Greenspan would refer to it. This tendency in human behavior allows bull markets to run for longer, stable periods, distributing gains over a period of several years and market crashes to be more sudden and steeper, lasting on average less than two years.
Surprisingly, the results of our analysis also indicate that investors tend to make money whether buying into a general market rally or into a drop. However, those who buy when market sentiment is lowest tend (value/contrarian) tend to outperform those buying when excitement is near all-time highs (technical/momentum).
On average, the market returns 14.2% on the year following a market crash, which is 95 basis points greater than the returns following a market boom. Investors buying after a crash averaged 11.2% and 13.6% annualized returns during the three and five years following a market crash, respectively, compared to 8.0% and 8.8% for investors buying after big market gains, when investor confidence is highest.
No one knows what 2009 will hold for investors, but history seems to suggest that the probability of long-term losses is much smaller after a market crash.