While Market’s Direction is Uncertain, Our Response is Predetermined

Two years ago we went to some effort to build a mental model for understanding what we see as the different stages of market declines. We believed then, as we do now, that having a proper framework for judging markets is an important behavioral element to managing emotions for clients. We think of our model as the anatomy of a bear market.

The basic premise is that not all market declines are equal. In fact, we believe while some should be monitored very closely, others are better left ignored. Context is the key to determining which is which, and the context of the decline determines how one should respond.

We believe the discipline of trend following is ideally suited to help provide context, as well as help clients navigate through the various stages of market declines.

We believe equity markets in 2024 are providing a real-time illustration for this mental framework. Judging from some reactions we’ve observed among some investors during July, one might believe the markets are in or on the cusp of impending doom. And yet, one need look no further than the previous quarter to find a more significant decline thus far.

In April, the S&P 500 Index fell almost 6% from its intra-day peak March 28 to its intra-day trough April 19. At no point did its trends of any meaningful duration even flirt with flipping from positive to negative. Consequently, our allocations never changed. Within 30 days, on May 15, the index had erased the deficit and made new all-time highs once again.

The April decline represented what we call a “stage 1” or “reversion to the mean” style decline. In our opinion, stage 1 declines are healthy retracements that should generally be ignored. In fact, we believe overreacting to a stage 1 decline can have damaging effects to long-term compounding, while also creating inefficiency from a tax perspective.

Of course, some stage 1 declines will turn into stage 2 and 3 declines, and with the benefit of hindsight it will appear the investor would have been better off exiting. However, we think this is a biased view.

Taking a more robust approach to analyzing market decline data over many samples shows the odds are against investors when they try time markets in a stage 1 decline. Our research tells us it is far better to ignore stage 1 declines, or sometimes even to buy during them, depending on what signals are being sent by a disciplined trend-following process. It is an approach that is never perfect, but also never confused. In our opinion, discipline and consistency generate more alpha than timing.

But that doesn’t make ignoring stage 1 declines easy. It may seem obvious, but we don’t think it’s a stretch to say that all market declines are surrounded by bad news. In other words, there is always something seemingly scary occurring when the market falls. Does one ever look at a 5% decline in stocks and say, “There is nothing bad going on!”?

Take the current set of facts, for example. We just had several nearly unprecedented events take place: a last-minute switch in a major party presidential candidate, a presidential assassination attempt, and a technology outage that grounded air traffic and halted banking transactions. Combine these with perceived weaker tech earnings and you have plenty of fundamental justification for a decline.

And yet, in 30 days is it so hard to believe that we won’t be making new all-time highs? In April, the justification for decline was economic data indicating persistent inflation that would take rate cuts off the table. That amounted to nothing. Will this time be different? Who knows.

For us, there is tremendous comfort in having a rules-based, data-centric approach. We don’t know what will happen, but we know exactly what we will do depending on what DOES happen (or is happening). Is it perfect? No, but it definitely beats the alternative, in our opinion.