You’ve all seen the recent news: major stock markets have cratered by 15% to 20% with much of the decline during the last two trading sessions. This is the third major stock market crisis of my 20-year career (preceded by the ’01 Tech Crash and the ’08 Global Financial Crisis), and fifth of my lifetime (the ’87 Black Monday and the ’97 Asian Currency Crisis).
Most of Henderson Rowe’s clients are experienced investors who are not prone to panic. But at times like these, it can still be helpful to share my experience about the potential risks and rewards investors may face during and following financial crises.
First, among the biggest risks you’ll face in the aftermath of a market crash are the few investment managers who called it right. Beware these managers. They’ll show positive returns even as global equity markets decline. They’ll appear on TV and radio. They’ll get famous, write books, and win awards. On the heels of their good fortune, they’ll raise billions in new assets. And afterwards … they’ll deliver terrible returns. For example, John Paulson raised $14B after predicting the Global Financial Crisis, only to return negative 65% over the next five years.
Even among our industry’s most accomplished academics, I’ve never seen evidence of persistent ability to predict a crisis. The person who timed the tech crash didn’t call the global financial crisis and isn’t celebrating their COVID-19 prediction. In fact, the same insights and understandings that lead to correct predictions can also lead to future mistakes. For example, the managers who avoided the ’01 Tech Crash also kept their clients out of Amazon, Google, Apple, Netflix, Tesla, Alibaba and Tencent over the following two decades. The lesson here is not to chase heroes from the last war – because the new war is always different.
Second, don’t trust models or managers who claim to predict or time financial crises. In fact, there is a popular joke that economists have identified 11 of the last 7 recessions. The poster boy for forecasting market crises is the lovable Nobel Laureate Bob Shiller, who has predicted every single market crisis in recent history … just three years too early. He has also predicted a few crashes that never materialized. If you follow Dr. Shiller’s PE Ratio, or the equally famous CAPE Ratio, you would have stayed out of equities markets altogether and missed out on tremendous growth.
Of course, there are many other timing models—for example, those focused on credit spread, yield curve shape, VIX, commodities price and other factors—which are developed after each market crash. These models are calibrated and backtested to the most recent crisis such that they would have accurately predicted a past that has already occurred. But these models are almost always wildly inaccurate with respect to future crises, and actually cause damage along the way through repeated false positives.
In conclusion, my experience and research lead me to offer the following key lessons to my students, friends and clients.
- There is no evidence that managers can time the market consistently. Ignore gurus and talking heads on television who claim otherwise.
- If you cannot tolerate occasional market crashes, take lower equity risk in your portfolios. That is the trade-off you must make.
- Models for predicting market crashes forecast them too early and too frequently. As a result, buy-and-hold investors generally take on more risk but enjoy greater returns.
- Managers are not miracle workers – they help you make sensible decisions and protect you from the worst tendencies of yourself and the market. Don’t trust managers who overstate their abilities.
- Humans tend to underestimate risk before it materializes, and overestimate risk afterwards. Accordingly, most successful investors agree it is better to buy stocks when a market is irrationally pessimistic than when it is irrationally optimistic.
Investors feel understandable angst during market crashes like the one we are currently experiencing. However, as noted above, these crises also drive irrational behavior that creates opportunities for those who stay calm. If you have any questions or concerns regarding your own portfolio, please reach out to your investment manager.
Jason Hsu, Ph.D.
Director, Henderson Rowe
Chief Investment Officer, Rayliant Global Advisors