There is an old adage on Wall Street: The market goes up the escalator and down the elevator. Stock gains tend to be small, relatively steady things, accumulating over years. Stock declines, on the other hand, can be violent, painful affairs. History shows selloffs are a way of life on Wall Street, testing the mettle of the most seasoned traders.
More often than not, history also shows it’s a good idea to buy the dip. Although executing on that advice can be easier said than done. Perhaps especially when the dips are more like a roller coaster drop—like the 12.4% fall in the Dow Jones Industrial Average for the week ending Feb. 28.
The Dow has existed for 6,200 weeks, and in that time, the index has declined more than 10% in one week just 17 times—less than 0.3% of the time.
The good news for investors is that after those rare events, stocks have had a tendency to rise in the ensuing four-week and six-month periods. The average gain in the four weeks after a selloff is 1.1%. The average gain six months later is about 7.5%.
Those might not seem like big gains, but investors do get paid for stepping in a buying in times of turmoil. The average gain for any four-week period over the Dow’s history is 0.5%. The average gain for any six-month period is 3.5%. More risk nets more reward.
That’s not the whole story, though: While stocks to have a tendency to garner above-average gains after a 10% drop in a week, the market only rises in about 55% of the four-week and six-month periods after a selloff.
In fact, investors can expect to make money in roughly 60% of any of the four-week and six-month periods in the Dow’s long history. That’s a little disappointing. So buying the dip isn’t a sure thing, but there are some factors to keep in mind.
For starters, it appears big dips beget more big dips. So investors can expect more volatility. That’s one implication of recent trading action.
Volatility clustering helps investors in this case. Nine of the 17 episodes of 10% or greater weekly declines happened in the 1930s. The Great Depression, it turns out, was truly depressing. Excluding the 1930s, the average gain for four-week and six-month periods following a selloff is 1.9% and 22.8%, respectively. Those are attractive returns.
And if investors believe that the coronavirus won’t push the global economy into another depression, they can be heartened by the fact that the market rose in 75% of the periods excluding the 1930s.
But investors should also be wary of small sample sizes. There are only eight 10%-plus dips to consider outside of the 1930s. Two happened in 1914. Another occurred in 1917. Two more bracketed the 1930s, in 1929 and 1940. The market fell more than 10% once in 1987 and in 2008.
No one knows what will happen this time, but history could perhaps strengthen the resolve of aggressive traders debating whether or not to jump into the market now.
“The coronavirus is reminiscent of 1990 in terms of stock-market effect,” wrote Stifel head of institutional equity strategy Barry Bannister, referring to the year Iraq invaded Kuwait. “A short, sharp, out-of-the blue shock that, after the fact, proved to have been painful, but economically overrated.”
There wasn’t a 10% weekly decline in 1990. There was, however, a 7.8% decline, and the market dropped six straight weeks around the August occupation. Oil prices doubled between July and October of that year. Gains started in July, the market started dropping then too. Apparently, financial markets knew the invasion was coming.
“The Fed had been cutting rates since June 1989, but accelerated the cuts in July 1990,” Bannister added. “The S&P 500 rallied back to the old high by [February 1991].”
Bannister’s historical example of a wartime recovery isn’t quite the same as a pandemic. But many events have knocked the Dow down, and more often than not, it bounces back quickly.
Write to Al Root at firstname.lastname@example.org, follow him @DowJonesAl