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The Difference Between Statistics and Strategy

Statement 1: the average year has between 3 and 4 corrections greater than 5%.

Statement 2: every year has between 3 and 4 corrections greater than 5%.

Statement 1 is a true statistic regarding the S&P 500 going back to 1928. It can serve as a helpful reminder that there is no reward without risk and that equity securities are inherently volatile (the current period notwithstanding). Corrections happen, even in good markets.

Problems start to arise when investors assume that because Statement 1 is true that Statement 2 must be true as well. Markets, unfortunately, don’t operate that way. The actual environment rarely looks like the average environment.

Since March 2009, there have been 21 corrections greater than 5%, but they were not evenly distributed. In 2009 and 2010, we saw 4. In 2013 we only saw 1. Thus far in 2017 we have yet to see any.

This behavior is rare, but not unprecedented. In 1995 the S&P 500 went the entire year without a 5% drawdown. In fact, the largest drawdown on a closing basis was only 2.5%, and did not occur until December.

You can bet that many investors fought this non-stop rally higher and many others sold out in the early going, “waiting for a correction” to “get back in” at a lower price.

But the correction never came in 1995 and the corrections in 1996 were not deep enough to provide an opportunity for investors who sold out in early 1995 to get back in at lower prices. The S&P 500 would gain more than 20% in 1996, 1997, 1998, and 1999 before ultimately peaking in March 2000.

To be sure, this was perhaps the strongest period in history for U.S. equities, and no one could have foreseen what was to come at the end of 1995. But that’s part of the point here. We could not reasonably predict what was to occur from 1996-2000 because the behavior of 1995 was not by itself a signal of anything. It was merely a deviation from the average outcome, which is not the exception in markets but the rule.

As I write, the S&P 500 is hitting yet another all-time high. Thus far in 2017 the largest drawdown on a closing basis has only been 2.8%, which would be the lowest since 1995.

The Volatility index (VIX) ended May at its lowest monthly close in history.

For those waiting for the typical correction or for the average level volatility to resume, this has been an immensely frustrating year. For everyone else, it’s been quite good as I outlined last week.

That’s not to say that we shouldn’t expect to see corrections with more frequency. We should. And it’s not do say that we shouldn’t be prepared to see higher volatility. We should as well. The statistics (average outcomes) say that both higher volatility and increased frequency of corrections are likely.

But there’s a big difference between statistics and strategy and this is where many investors go awry. There were four corrections in 1996. Volatility did indeed rise from the extreme low levels of 1995. But that “reversion to the mean” was not a strategy; it did not help investors who sold in early 1995 on the hopes of buying in at lower prices.

Which is why basing your investment strategy on interesting statistics can be a dangerous game.

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Related Posts:

The Difference Between a Prediction and a Probability

Interesting vs. Actionable

Pundit or Professional

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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