Is December's Stock Market Sell-Off a Bad Omen?

When stocks do suffer sharp sell-offs, what are their subsequent performances? Do sudden losses typically signal future problems?

John Rekenthaler 7 January, 2019 | 12:58AM

Lehman Brothers Auction

December brought an unfamiliar emotion: investment dismay. For the first time in a long while, stock market problems made the headlines. Few US adults entered the New Year without realising that equities were slumping. Most, however, shared my position: I knew that stocks were down, but not by how much, nor how the month rated among stock market history.

The S&P 500, it turns out, had a total return of -9.03% in December 2018. That places the month as the 11th worst over the past half century, from 1969 until the end of 2018. Which sounds a bit worse than the reality. 

Although only 11 months had monthly losses of at least 9%, another seven fell between 8% and 9%.

Worst Calendar Months

Only three times during the 50-year period did the S&P 500 drop more than 12% during a calendar month: October 1987, August 1998, and October 2008. The first and third dates made the investment history books, one being the month that contained "Black Monday" and the other occupying the centre of the financial crisis. In contrast, the August 1998 downturn is less-remembered.

The surface explanation is clear. Russia devalued its currency and the giant hedge fund Long-Term Capital Management went kaput. Less obvious is why those events damaged US stocks so severely. Russia was an isolated economy, and Long-Term Capital Management a single investment fund. Those butterflies flapped, but they did not greatly affect the global weather.

Consequently, domestic equities immediately recovered – and then some. The S&P 500 gained 6% in September 1998, another 8% in October, 6% in November, and 6% yet again in December. What bothered investors greatly in August, quickly bothered them not at all. It is difficult not to arrive at the conclusion that August's sell-off represented a fine buying opportunity. Stock shareholders overreacted.

What Happens Next?

When stocks do suffer sharp sell-offs, what are their subsequent performances? Do sudden losses typically signal future problems, as with October 2008, which was followed by four additional months of pain? Or, as was the case with Black Monday and in the summer of 1998, do equities tend to rebound quickly?

Most of the time, buying on the dips proved profitable. Setting aside December 2018, where of course we do not know the ultimate outcome, the S&P 500 fell by at least 8% on 17 occasions. Six times, stocks immediately rose. On another five occasions, the ultimate recovery didn't occur for another month or two, but the incremental losses were modest, at 5% to 10%. Staying invested would have been the correct decision.

Lessons From History

The remaining six cases, however, are worrisome.

1) November 1973: Stocks had been slumping all year, then fell another 11% in November. A buying opportunity it was not. Those who put money to work at month's end, sensing a bargain, had to wait almost a year before stocks began to right themselves – and considerably longer than that to break even. That inflation was rising, thereby eroding real returns, made a bad story even worse.

2) February 2001: This downturn was a full year old. It was tempting to think of February's 9% decline as the bear market's final blowout. Such was not the case. This was merely one bad month of a long series. Before all was said and done, an S&P 500 portfolio would lose an additional 33% of its value, and the upturn would not begin until late 2002. Ouch.

3) September 2001: Another false alarm. The bottom remained 12 months away.

4) June 2008: In the summer of 2008, the housing market had been troubled for a while, by rising defaults from subprime real estate loans. Although these problems had caused occasional problems for equities, the damage had not been large because the housing market's woes were viewed as being mostly self-contained. That view began to change in June – correctly, as it turned out. The stock market's losses were the direct opposite of a buy signal. They were instead an omen.

5) September 2008: As above: the housing market continued to unravel. The month's sell-off was a precursor. More pain would follow.

6) October 2008: After October, an argument could be made that stocks' losses had created a genuine opportunity. Equities would struggle for the next four months, and lose another 23% before righting themselves, but in the grand scheme of things, those costs would be dwarfed by stocks' huge gains from spring 2009 through autumn 2018. But who views schemes that grandly? Few would have been happy during 2008's long, long winter.

In summary, there have been only three prolonged bear markets during the past half century: 1) 1973-74, 2) 2000-02, and 3) 2008. Each time, stocks posted at least one steep monthly loss early in the downturn. Thus, to address this column's second set of questions, although buying after stocks take large monthly damage has mostly proved profitable, the tactic has not been foolproof. About one third of the time, it would have caused significant regret, at least for the short term.  

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.