How Much More Pain To Bear Before I Sell All My Stocks?

buyers and sellersRida Morwa:  Many investors are wondering today: Should they sell all their stocks? I will attempt in this article to answer the question.

Establishing the Facts: Are we in a “Market Correction” or “Bear Market”?

How painful is the further decline going to be before we reach a bottom?

I have provided an analysis of 3 possible scenarios for the S&P to bottom (Optimistic, Worst-Case, and Likely Scenario).

Although my analysis shows that the S&P is likely to decline another 4.2% to reach a bottom of 1780, it is best not to sell and hold on to the equity positions.

Definition of “Market Correction” and “Bear Market”

  • Market correction: is defined as a drop of at least 10% or more for an index or stock from its recent high.
  • Bear market: is defined as a 20% or more decline in stock prices.

Officially, we are already in a “market correction” as per its definition. Yesterday, the S&P closed at 1859, down by 12.7% from its high in May 2015 when the S&P was at 2130. 

Quick statistics about “Market Corrections” and “Bear Market”.

bear1

Establishing the Facts: Are we in a “Market Correction” or “Bear Market”?

As shown in the table above, Bear Markets mainly happen when there are fundamental changes to the economy or the markets, such as a recession, exuberant market valuation, or bursting bubbles  like the housing price bubbles. “Market corrections” tend to happen for no specific reason.

So let us have a closer look at what is happening in the headlines: The markets are concerned with slowing growth in China, falling oil prices, and higher interest rates by the Fed. What is new in the above headlines? Nothing really.  China’s growth has been slowing for several years, oil prices have been in free fall since 2014, and the Fed has well prepared the markets for its minimal hike of 0.25% in December 2015 and made it clear that future hikes will be slow and gradual.  So why are the markets crashing? In my opinion, this is just a healthy correction, as there is nothing fundamentally wrong. The US economy is growing at a healthy pace, while we are not seeing any major economy such as China, Japan or Europe falling off the cliff. In fact, most major economies are pumping money and lowering their respective interest rates, which should be encouraging for the stock markets.

The view that we are in a “Market Correction” and not a “Bear Market” is shared by most Banks and market analysts, including Charles Schwab and Deustche Bank. 

How painful is the “Market Correction” going to be?

Now that we have established that we are most likely in a “Market Correction”, I would like to set out 3 scenarios about how painful this correction is going to be:

1)     Optimistic scenario: An average market correction of 13.3% being the historical average loss in market corrections, translating into another 0.6% loss to the S&P.

2)     Worst-case scenario: A maximum of 20% loss, as defined by a “market correction”, translating into another 7.3% decline in the S&P.

3)     Likely scenario: In order to arrive to the likely scenario, we have to look at one of the “main drivers” and best indicator for the market collapse, which is the price of crude oil.  The correlation between the decline in the S&P index and the decline in the WTI crude oil for the past 3 months has been roughly 0.35% for the S&P for each 1% decline in crude oil. Assuming that the bottom of WTI crude oil will be at $25 as suggested by Larry Fink, Blackrock CEO, then we are looking at around 10% decline in crude oil from the current prices, translating to roughly about another 4.2 % decline in the S&P based on current price levels.

The following is the table summarizing the 3 situations:

bear2

Although it is very difficult to predict with accuracy how much further down the market will go , my analysis suggests that the S&P is likely to bottom around 1780, roughly a 4.2% decline from yesterday’s close of 1859 (S&P closing price for January 20, 2016).

Other Important Statistics about Market Corrections

  • Stock market corrections happen often (about once a year).
  • Market corrections rarely last long (about 4 months)
  • They mostly happen when small stocks significantly lag large-caps stocks.
  • They should only matter for short-term traders, and not long-term ones.
  • In most market corrections, there is a sharp V shaped recovery, with very little bottom-building or retracing.
  • Stock market correction is often a great time to pick up high-quality companies at an attractive valuation.

What to Do?

  • Don’t make hasty decisions. Be patient, and take the long view.
  • Market recovery will come sooner than you expect.
  • Do not try to time a bottom, as recovery will be sharp and quick. You will most likely miss it.
  • Make sure you are not on heavy margins which will magnify losses.
  • Stay Invested. Despite all the corrections and bear markets, equities have fared the best in the long run. The S&P returned a “compounded annual growth return” (CAGR Annualized return) of above 7% both over the past 10 years and the past 20 years.
  • Go bargain hunting for the best stocks, especially high-dividend ones!

This article is brought to you courtesy of Rida Morwa.

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