Words on wealth: how quickly can markets recover from a crash?

How quickly do markets recover from a crash?

Words on Wealth

Last week, in reaction to the US government’s extraordinary imposition of tariffs on goods coming into America from almost every country in the world (including islands inhabited only by penguins), stock markets understandably tanked. By the time you read this, they may have recovered somewhat or dropped further. 

Investors should rightly be worried – they are seeing the value of their savings plummet. But this is the nature of stock-market investments. Even without the incomprehensible actions of US President Donald Trump, it was fairly inevitable there would be a “correction” at some point, particularly in the US market, whose giant tech stocks have been massively overpriced for some time.

The advice from your trusted financial adviser, if you have one, will be not to panic and sit tight until markets recover. But how long should you reasonably expect that to take?

Worst-case scenario

If we are entering a period akin to the Great Depression of the 1930s, it would be horrible – there is no disguising the fact. It took 25 years for the US stock market, as measured by the Dow Jones Industrial Average, to recover to its pre-crash levels after the 1929 crash and the subsequent depression – the index broke through its 1929 high in November 1954. 

Some commentators believe we are, indeed, entering another Great Depression, arguing that the protectionist actions of the Trump administration echo the policies introduced by President Herbert Hoover in the 1930s. Hoover’s Smoot-Hawley Tariff Act (it was an Act, passed by Congress, not an executive order, as in this case), which imposed heavy tariffs on imports, triggered a global trade war, leading to a worldwide decline in trade. The obvious difference is that the Smoot-Hawley Act did not cause the 1929 crash; it was enacted in response to it, as a solution. But mainstream economists are of the view that it had the opposite effect of what was intended – to boost local production – leading to a deeper, longer economic depression than might otherwise have been the case.

Last week, the markets tumbled as a direct result of Trump’s tariff onslaught. If the tariffs are maintained and there is a prolonged standoff between America and the rest of the world, I don’t see how global trade will not decline. US citizens are the world’s most voracious consumers, and it’s been to their advantage that, for many decades, they have been able to buy cheap consumer goods imported from countries that have substantially lower production costs.

Less scary scenarios

On a brighter note, if we look at more recent downturns, we find that recovery periods are relatively short and, in some cases, very short. Peter Urbani, an analyst well-known in local investment circles who now runs a consultancy firm, KnowRisk Consulting, in Wellington, New Zealand, recently circulated a LinkedIn post looking at the recovery periods of the major stock-market downturns of the last four decades. 

The US market, as measured by the S&P 500 Index had, at the time of Urbani’s post, dropped by 15.8%. Given that a market needs to rise by a higher percentage than it has fallen to attain its previous level, Urbani worked out that the market would need to rise by 18.7%. This could be achieved over about two years if the market returned its long-term average of 9% a year. However, he notes that markets tend to rise more sharply after a plunge, so one could be looking for less time to make up the loss.

“It is not unreasonable or without historical precedent for post-drawdown returns to be significantly higher than the long-run average. In fact, the five-year average annual growth rate post large drawdowns for the S&P 500 is 14.7%, and the 12-month average is 34.8%. Plugging those sorts of numbers into the formula gives much more encouraging expected recovery times of one year to six months, respectively. The caveat, of course, might be that we are not done yet or that valuations post the drawdown remain high,” Urbani said.

Urbani analysed the following four US-market downturns using the S&P 500 annual compounded total return (which includes reinvested dividends), calculated monthly:

• 1987 oil crash: Between August and October 1987, hit by a drop in the price of oil, the S&P 500 Total Return (TR) Index dropped 29.6%. The required return to break even was 42%. The time to recover at the average rate (9%) was 49 months, but the index had recovered by mid-April 1989, within 17 months, or almost three times faster than expected.

• 2000-02 tech crash: In 2000, the bubble caused by overpriced tech companies burst, leading to a rapid decline over the next two years during which the index lost 44.7% of its value. At the average 9% growth rate, the index should have taken 83 months, or nearly seven years, to recover. But it actually recovered in four years – from its low in August 2002, it surpassed its pre-crash high in August 2006.

• 2008 Global Financial Crisis: The S&P 500 TR Index dropped an eye-watering 50.9% between October 2007 and January 2009, with the steepest declines coming in late 2008. The required gain to recoup that loss was more than 100%. This would have taken between eight and nine years at the average 9% growth rate, but the market recovered in three years, reaching its pre-crash high in February 2012.

• 2020 Covid-19 crash: In the first couple of months of 2020 the index dropped by 19.6% as governments instituted lockdowns to fight the virus, effectively shutting down the world economy. But the markets recovered remarkably quickly – they bounced back in three months, 10 times faster than the 9% average growth rate would have afforded. 

I won’t go into the reasons why, in some cases, the markets bounced back so quickly. The fact is they did, and investors who had not sold in a panic recouped their paper losses and may have subsequently profited beyond their expectations.

* Hesse is the former editor of Personal Finance.

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