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How Investors Respond To A Market Crash

By Nicholas Colas of Convergex

Tell ‘Em That It’s Human Nature

The surge in volatility over the past week enabled this year’s aggregate number of plus or minus 1% moves in the S&P 500 – currently 40 – to exceed last year’s total of 38. There were nineteen positive 1% or more days in 2014, and 19 negative days compared to 22 up days and 18 down days this year. We need 14 more 1% days in order to reach the annual average of 54 since 1958, representing only 16% of the next 86 trading days left in the year. As we progress throughout the balance of 2015, we expect to encounter more of the volatility of the past week than the past few years. One percent or more days tend to pick up by the fifth or sixth year of bull markets such as the rallies of the 1980s, 1990s, and 2000s, and we are in our seventh. Additionally, the VIX often hits its annual peak in October – for example last year – more so than any other month with a total of 5 since 1990. December may statistically register as the quietist month with 7 annual troughs over the past 25 years, but this year may prove different due to the uncertainty surrounding the Federal Reserve’s timing of an interest rate hike.

What do you think moved financial markets over the past week of turbulent trading? Perhaps slowing growth and unstable equities in China, renewed fears of deflation, the impending rate hike by the Federal Reserve, or all of the above. Each example certainly played a role. One underappreciated culprit irrespective of economic fundamentals, however, lends itself to volatile capital market environments: investor psychology.

In the midst of turmoil among asset classes, investors tend to make irrational decisions, such as panicking and liquidating at inopportune times. Nobel Prize-winning Psychologist Daniel Kahneman helps explain ill-conceived reactions to the market with his concept of loss aversion. That’s the fear and feelings of loss surpass the joy one may receive from a similarly sized potential gain.

In order to frame this discussion of volatility, we dug up old surveys of institutional and individual investors that recorded their responses to the 1987 market crash. They were conducted by Nobel Laureate Robert Shiller in October of that year, just as the field of behavioral finance started to garner credibility and attention. We recognize the market has evolved rapidly and grown in complexity since with the development of high frequency trading, for example, but our minds still work the same.

These surveys, therefore, serve as a useful case study to glean insight on the psychology of investors during significant market events. Here is a brief breakdown of the results (link included at the end of this note):

  • Survey methodology: Shiller sent out a questionnaire to 125 individual investors about the downturn in the stock market from October 14-16, 1987, and received 51 responses. He also sent out another survey following large price declines on the morning of October 19, 1987 and garnered 51 responses as well. Shiller then conducted a full study of 605 individual investors and 284 institutional investors’ responses to questionnaires distributed after October 19th, 1987 that accounted for the news of the day.
  •  "No clear-cut reaction to news”: Shiller asked participants to rate the importance of news stories that the media listed as possible causes of the stock market selloff from October 14-19, 1987. The 200-point drop in the Dow on the morning of the 19th was the highest rated among both institutional and individual investors, followed by the fall in prices during the prior week in second or third for either cohort. Other top of mind concerns, particularly among Institutional investors, was the recent climb in interest rates. With that said, Shiller concluded that investors likely reacted to price movements themselves on days of large market declines rather than specific news stories.
  •  “Much talk, much anxiety…”: Almost one fourth of individual investors and about 40% of institutional investors “reported experiencing a contagion of fear from other investors”. Of the individuals who sold on October 19, 1987, over half “reported experiencing contagion of fear”. Additionally, a little over one third of individual investors and slightly more than half of institutional investors said their conversations touched on the events of 1929 leading up to the 19th.
  •  “Many investors thought they knew what the market will do”: Just shy of 30% of both intuitional and individual investors said “yes” to a question that asked if they “had a pretty good idea when a rebound was to occur” on October 19, 1987. Many individuals said they knew based on “intuition” or “gut feeling”, while several institutional investors reported “gut feeling”, “historical evidence and common sense,” or “market psychology”. Obviously, the remaining 70% felt differently.
  •  "Investors thought investor psychology moved the markets”. Several survey participants attributed the price declines from October 14-19, 1987 to the “overpricing of the market before the crash” or stop-losses on the institutional side. Another theme included investor irrationality, which garnered a quarter of individual and institutional responses. Moreover, 67.5% of individual investors and 64% of institutional investors said the theory of investor psychology rather than fundamentals explained the selloff. By contrast, Shiller noted that results obtained previously from a random sample of institutional investors showed 79% held an individual stock on a normal day due to a theory about fundamentals. 

In sum, Shiller determined that the crash occurred due to investor reaction to price and investor reaction to each other: “the communications proceeded rapidly, and prices were checked with great frequency”. Fast forward to today, and this theory compounds itself in an age when communication, stock quotes, and financial news are all quickly available with simple swipes of the finger or a few taps of buttons. Consequently, the surveys from nearly 30 years ago inform Shiller’s most recent commentary on the collapse in U.S. stock prices over the past week. While most economists blame China, Shiller blames human nature.

We look to the number of annual one percent days for the S&P 500 and seasonal patterns in the VIX – the market’s designated “fear indicator” – for historical context on what to expect in terms of market volatility relative to each year and economic cycle. The results highlight Nassim Taleb’s theory of Black Swans, or that outliers (in this case outsized moves in stock returns) occur more frequently than the math of Normal Distributions suggests. Consider this list of stats broken out into ten bullets (tables and charts of the data follow this note):

  • The average annual number of plus 1% moves in the S&P 500 from 1958 to 2014 totals 53.6. This includes an average of 27.5 days up 1% or more, and 26.1 days down 1% or more. 
  • The period from 1958 to 1970 was much less volatile, with an annual average of only twenty seven 1% or greater days per year. From 1971 through 2014, the annual average increased to 61.5 (32 up, 29.5 down). Since there are about 250 trading days in the year, this suggests a 25% chance that stocks rally or selloff by 1% or more in any session. 
  • From 2010 to 2014, the average is 59.8 days (31.4 up, 28.4 down). Over the past three years through 2014, the average falls to 42.3 (23.3 up, 19.0 down). 
  • Looking at the pattern of the annual 1% days in the S&P 500 since 1958, market swings typically occur in the beginning of a bull market, wane, and then climb higher towards the end of consecutive annual gains in equities. Using the rally in the 1980’s up until the market crash, for example, shows eighty two 1% or more moves in 1982, which declined to 28 by 1985. This figure, however, picked back up to 61 in 1986 and 95 in 1987 during the fifth and sixth years of stock advances. Likewise, there were 118 plus or minus 1% moves in 2009 at the start of the most recent bull market, which fell to 38 in 2014 or its sixth year of gains.
  • Given that we passed last year’s total of thirty eight (19 up, 19 down) 1% days this week – currently at 40 (22, 18) – we expect that volatility will continue during the remaining four months of 2015 as part of a reversion to longer term averages. One percent days accelerated in the fifth and sixth years of the bull markets in the 1980s, 1990s, and 2000s. We are now in our seventh year as the Fed allowed the capital markets more time to hibernate with its easy monetary policies, but investors are waking up to the imminent tightening measures that may take effect as soon as this year.  
  • Getting back to the annual average of 53.6 dating back to 1958 requires 13.6 more days of plus or minus one percent moves, or 16% of the next 86 trading days of the year. Reaching the annual average of 61.5 since 1971 would take 21.5 more days, or a quarter of the trading days left in 2015.
  • The CBOE VIX Index has registered both annual high and low points throughout most months of each year since 1990, but the peaks and troughs do tend to cluster...
  • If the VIX were randomly distributed across time, you’d expect each month of the year to post both two highs and two lows over the last 25 years. Yet this is not the case; some months have substantially more or less than that average. October’s price action, for example, typically experiences the most volatility with the VIX hitting its annual high five times during this month over the measure’s existence. The “fear index’s” performance last year added to this total. Also, note that the VIX has never troughed in October in any year since 1990.
  • By contrast, investors don’t usually run into much market noise in the month of the “Santa Clause rally”. The VIX has fallen to its annual bottom in December during seven years. This measure only peaked in December once back in 1996 amid a weakening dollar and turmoil in China’s financial markets.
  • January, on the other hand, is a mixed bag with the VIX peaking and bottoming during four years each. As for the remaining months, most put at least one point up on the board but are less volatile comparatively: February (0 high, 0 low), March (1, 2), April (3, 1), May (1, 1), June (3, 1), August (3, 2), September (2, 0), November (2, 2).

What does this signal about trading during the balance of 2015? Get used to the recent wide swings in the market because they are likely to continue as we head towards the most volatile month of the year: October. Perhaps December will provide some relief during the typically quiet month. But with the Fed likely pushing off raising short-term interest rates past September, Santa may bring coal this year as opposed to the gift of historically low rates that supported equity valuations over the past six.