What Should You Do When the Market Crashes? Stay the Course.

“Stay the course.”

-Ancient metaphor

As the market started sinking early in the virus crisis, I received a number of calls from friends and colleagues asking what they should do. I said sit tight and continue buying stocks. Easy call -- it’s what I say all the time! I make no claims to being a market prognosticator. I wouldn’t be surprised if we hit new lows later this year … or new highs; the uncertainties are unusually great. But that doesn’t change the advice.

More recently, I have received queries from people (including a university finance professor) puzzled at the resiliency of the U.S. stock market in the wake of the unprecedented spike in unemployment and the sudden contraction of the economy due to the pandemic shutdown. Since the brutally quick sell-off in February and March created the first bear market in 12 years, the S&P 500 has rallied over 35% and is now over 3000 again, a level first reached in just the 4th quarter of 2019. The reasons for this explain why the aforementioned “advice” (which I prefer to think of as an ongoing strategy) is sound. We have mentioned most of these things in various pieces over the years, but now is a good time to collect them together and, in so doing, hopefully make the gyrations to come more bearable.

First, a lot of money goes into the market “automatically” now as money is deducted from paychecks and invested in 401k plans and other pension vehicles, much of it going into “index funds” (more on this later). This steady flow gives stocks a natural “buoyancy” that didn’t exist in the past. Of course, the market can fall fast and hard as it did earlier this year, but over time these investment flows inexorably push the market higher. Second, bond yields are at all-time lows and as we discussed just earlier this year, may stay that way for a long time, if not in perpetuity. This makes them a poor alternative to stocks for both individuals and pension funds that have 7% actuarial target returns to meet future liabilities. Third, the market simply consists of far fewer companies today than in the past, both in absolute terms and especially in terms of GDP. The Wilshire 5000 stock index was created in 1974 to be the broadest measure of U.S. stocks available and got its name from its creator, Wilshire Associates, due to the number of companies initially in it. By 1998, the number of companies represented in the index was over 7500; today it is under 3500. Yet, GDP is 13x greater today than in 1974. We have discussed some of the reasons for this phenomenon in the past and will revisit them, but the point to be made here is that there is a vastly larger sum of investable funds today chasing a shrinking number of targets, the resultant stimulus predictable.

Finally, the way stock indexes are created makes them naturally biased towards the economy’s “winners”. Stock indexes such as the S&P 500 (and the Wilshire 5000 and virtually all others save the Dow Jones Industrial Average) are “cap-weighted”, meaning that the representative amount of a company it contains is proportional to the company’s market capitalization (it’s total market value, equal to the price per share times the number of shares outstanding). Thus, as a company becomes more valuable (like Amazon in recent years), it becomes a greater share of the index and as a company’s price fades (like GE in recent years), its participation in the index diminishes. And, for an index such as the S&P 500 with a fixed number of companies (only the 500 largest cap), participation is dependent on being in that select group. Thus the index tends to track companies and sectors that are performing well over time. For example, financial stocks accounted for almost a quarter of the S&P 500 during their heyday in the early 2000s, but now make up barely 10% of the index; with technology stocks taking the “reverse” trip. Note: the DJIA is a price-weighted average and doesn’t benefit from this effect to the same degree, but the Dow regularly substitutes new, better-performing companies for laggards, something often overlooked. For example, the Dow has replaced 12 of its components since just 2000. The Dow of 2000 would be far lower today than the reconfigured version. This “selection bias” is one of the reasons (low cost is another) why indexing is such a popular and successful strategy. The Vanguard S&P 500 Index Fund (symbol VFINX) has outperformed over 98% of funds since its creation in 1976.

So, ignore the news and keep buying. If the market hits new highs soon, great; if it hits new lows, you’ll be buying “low”, in the long run that’s great too. Stay the course!

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