Beware the Falling Market Knife

A global share market rout is not your everyday event.

Japanese share investors have witnessed firsthand — albeit over two decades — what a 80+% collapse looks and feels like. This was death by a thousand cuts. Down, up, sideways, down — it was a long and head-scrambling path to financial oblivion.

The Great Depression correction took place over a three year period. You can see it on the charts, but we really can’t comprehend what it was like to live that nightmare on a daily basis.

The fact we’ve never personally experienced a collapse of this magnitude is why we cannot fathom the prospect of it happening.

The past three decades have conditioned us to prosperity.

Share markets have risen 14-fold.

House prices (especially in Melbourne and Sydney) have risen by a similar multiple. The median income is $80,000 (according to latest ABS stats).

On average, we have bigger and better furnished homes. We travel more and enjoy the cafe lifestyle. Our expectations are much higher than in the 1980s.

This position of improved wealth is courtesy of the following: home equity loans, low doc lending, car loans, leases, margin debt, credit cards, 48 month interest free loans, payday advances, HECS debts.

The very commodity that has created our world of prosperity — debt — is the one now threatening to tear it asunder.

We’ve been conditioned for so many decades to believe the world functions in a certain way. For 30-plus years, debt has been our servant. But what happens if debt suddenly and violently turns on its master?

Prosperity turns into poverty.

Should this be the case, the world as we know it would become unrecognisable. All our preconceived notions on how markets should react (based our recent experiences) will be challenged.

The major market corrections in recent history — 1987, 2000 and 2008 — have taught us three things:

  1. Markets do fall 50+% in value
  2. Markets eventually stage a recovery (and in the case of the US, they recover to new highs)
  3. You can count on one hand the number of institutional economists or analysts who predicted the major correction.

Starting with the last point first, forget about receiving any advance warning of an imminent market catastrophe from the mainstream.

It simply is not in their best interests to present a ‘what if’ scenario. You have to do your own homework and decide whether markets are on stable or precarious grounds.

As for the other two points, we’ve learnt markets can be tough but also forgiving. This is the lesson from recent corrections. It’s this experience that frames our thinking on what may happen the next time the market does a ‘dummy spit’.

But ‘what if’ the next downturn is a one in 100 year event?

‘What if’ the market turns brutal and unforgiving? We may well see a dark side of the market for which we are psychologically unprepared.

In the first part of this week’s Markets and Moneys, the historical and mathematical cases for a potential seismic downturn were presented for your consideration. Naturally, this doomsday scenario was dismissed as a fantasy of my destructive thinking.

Yesterday was the reasoning behind my investment motto of ‘winning by not losing’. The deeper the fall, the steeper the climb to recovery.

A loss of 90% requires a gain of 900% just to break even. Those kinds of returns do not come every day. They take decades to accumulate.

It doesn’t take too many brain cells to figure out that avoiding the devastating loss in the first place would be the preferred outcome.

The difficulty with ‘stepping to one side’ is that we don’t know when the next substantial correction will come. You could be missing out on further gains by waiting in cash.

Hence, the need for share exposure based on your tolerance for losses.

This approach to asset allocation puts you in the driver’s seat.

Assuming you manage to sidestep the worst of a catastrophic market downturn, how do you participate in the recovery?

In the midst of market panic, how do you know when to buy? You’re nervous and wondering if the market could fall further. Fear does funny things to your judgment.

This dilemma of when to buy into a falling market is why a market sage coined the term ‘don’t try catching a falling knife’.

Catching a falling knife, investing in a down market

Source: terraseeds.com

Not knowing when the knife is going to hit the floor makes buying into a falling market risky business.

Conventional wisdom is a 50% correction would be a screaming buy. You’ll have the chance to buy two shares for the price of one.

But what if the 50% correction is a whistle stop on the way to a 90% correction?

The following table shows the losses that would be incurred depending upon when you buy into the correction (assuming a 90% correction):

Buy in when market corrects

% loss if market falls 90% in value

50%

80%

60%

75%

70%

66%

80%

50%

To assist in understanding the chart, let’s say the market starts at 100 points.

A 50% correction would take it to 50 points. If the market falls 90%, it would devalue to 10 points. This is a 40 point (or 80%) loss on your buy in level.

Catching this falling knife would nearly sever an artery.

The other point to note in the imperfect science of how best to take advantage of a depressed market is that markets do not fall in a straight line.

It could take years for the market to zig and zag its way to exhaustion, as we’ve seen with The Great Depression and Japanese examples.

This is where long term valuation tools and market sentiment indicators — Shiller P/E 10, Tobin Q, Market Cap/GDP ratio, Advisor Sentiment readings, VIX, etc. — are useful in determining whether markets offer sufficient discount to warrant investment.

While the math may be giving you the green light, you must recognise that in a market meltdown fear could well drive valuations to obscenely low levels.

How do you catch the falling knife in this scenario? Little by little.

The only way to buy into a market lurching from new low to new low is progressively.

Have a pre-determined dollar cost average strategy. Work out how much each week, month or quarter you’ll systematically invest into the heavily discounted market.

Easing your way into a deeply discounted market provides you with the best opportunity to minimise your downside and maximise your upside.

This is the strategy Gowdie Family Wealth will be employing when the market signals it’s time to swap cash for absurdly cheap equities.

In the meantime, a great deal of patience is required.

Vern Gowdie
For Markets and Money

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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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