After stocks posted the most volatile stretch of trading since the 1930s last week, the Dow is down about 10% from its May highs. Some feel this is a bad omen. If the market is forward-looking, perhaps the recent sell-off is indicating a second recession. Maybe something worse.
It very well could be. But there's no way of knowing today. The old quip that analysts have predicted nine of the past five recessions is spot-on. The biggest driver of any economy -- confidence -- simply can't be forecast.
That limitation is painfully evident in the stock market. There's a long history of big market pullbacks that ended up as much ado about nothing. Here are four examples.
April 2010-July 2010: Dow falls 14%
You don't have to look far to find a market pullback on par with what we've just experienced. Just last summer, fears of a double-dip recession exploded as Greece's finances unraveled and the Federal Reserve's monetary policy medicine wore off. Google searches for the phrase "double dip" went up 20-fold.
The fears never materialized -- at least not as investors predicted. Intervention by the European Central Bank and a new round of quantitative easing by the Fed sparked a rush back into risky assets. Within a year, the Dow rallied more than 30% and job creation hit a multiyear high.
March 2005-April 2005: Dow falls 8.5%
After dropping interest rates to then-historic lows early last decade, the Fed began inching rates up ever so slowly in 2004. As inflation picked up in early 2005, Fed Chairman Alan Greenspan told Congress he felt interest rates were still "fairly low." By most accounts, those two words alone gave investors a sense that the Fed would start aggressively raising rates, pushing the economy into recession.
A recession eventually hit, of course, but not for years, and not because of high interest rates. After the 2005 pullback, the Fed stayed its course of gradual interest rate increases, the economy boomed for another three years, and the Dow rallied more than 40%.
July 1998-August 1998: Dow falls 19%
How misguided nostalgia can be: Most remember the late 1990s as an investing utopia, but the summer of 1998 actually brought one of the biggest market plunges since the Great Depression.
After Russia unexpectedly defaulted, the global economy went into shock. Commodity prices plunged, creating more worry that other commodity-centric countries would also collapse.
Perhaps most caught off-guard was a hedge fund called Long Term Capital Management. With a few billion dollars of capital, LTCM borrowed roughly $100 billion to purchase derivative contracts with exposure to more than $1 trillion in assets -- truly one of the grandest adventures in leverage the world had ever seen.
The fund essentially went bankrupt after Russia defaulted. That created its own panic. With a portfolio that size, and with every Wall Street bank intertwined in the mix, the thought of liquidating LTCM's assets scared investors silly. It was the first true experience with "too big to fail." Economists weren't just worried about a recession. The word depression was on people's minds.
Wall Street eventually bailed out LTCM, mainly to save themselves. Fears subsided almost instantly, and 1998 and 1999 ended up as two of the strongest years the country has ever seen.
August 1987-October 1987: Dow falls 34%
Most investors actually do remember this period. It lived in infamy as the crash of 1987, when stocks fell 22% in a single day.
But there are two important lessons from the 1987 crash that often go ignored.
First is how inconsequential it was to long-term investors. Stocks recovered about half of total losses within days of the crash, and were at fresh highs within two years.
Second is the cause. While still debated today, most accept that the crash of '87 was triggered by an inane financial product called portfolio insurance, in which computers automatically sold stocks to avoid losses, hedged with put options and futures contracts. Portfolio insurance could have worked on a small scale, but became so popular in the 1980s that it ended up cannibalizing itself: Normal stock selling begot more selling, which begot more selling, and so on. It spiraled until computers were effectively trying to sell the entire market at once -- and not because they were bearish on the value of businesses, but simply because they were programmed to sell.
Remembering that lesson is as important today as it has ever been. Computer trading now makes up some 60% of total market volume. These computers don't care about economic data, and they aren't studying the intrinsic value of businesses. They're merely trying to outwit one another, often by holding stocks for a few hundredths of a second. The volatility these computers are capable of creating is crucial for long-term investors to be cognizant of -- or better yet, to ignore. A big market plunge isn't always a harbinger of real economic pain. It can be nothing more than a few computers playing tag.
Eye on the prize, Fool
There are plenty of other examples. Corrections of 10% or more are almost an annual ritual. The lessons gleaned from each one should be clear: Markets are volatile; get used to it. Markets aren't perfect seers; they often misjudge the future. And whatever has markets wound up will eventually work itself out.
This too will pass; patient investors will win. That will be just as true over the next 50 years as it was over the past 50.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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