A theme of this email is that it’s useful to assume the market price is approximately right. It’s safer than trying to get cute and making the classic mistakes of a) timing the market or b) overtrading.

Overtrading is what happens when you try to trade your way to superior returns by buying and selling individual stocks. And it’s bad because most people — even professionals — do a bad job of it. It’s a bad strategy because trading commission fees drag on returns.

Timing the market is about trying to move money in and out of the market at the optimal moment. It’s bad because most people, even professionals, do a terrible job of it. They tend to buy when everyone’s at their most optimistic and sell when everyone’s scared. 

Right now, everybody’s scared. The classic mistake would be to take your money out of stocks now, and wait for things to blow over. But if you have the wherewithal, it’s smart to buy in when everyone else is worried. As they say, buy when there’s blood on the streets.

So let’s take a look at where we are now, and how the market of today compares to previous bear markets. How bloody are the streets?

Bravery pays

When the market drops 20 per cent from its highs, they call it a bear market. Right now, the S&P 500 — the global benchmark equity index — is down 17 per cent from its highs, though last month it was down 25 per cent. The Eurostoxx 600 index of European shares is down 8.6 per cent, though at the end of September it had dropped 22.6 per cent from its highs. So it’s safe to say we’re in bear market territory. 

I don’t want to get into the specifics of valuation and fundamentals and interest rates today. That’s for another time. What I want to know is, what happens when you buy stocks after they fall a lot?

I looked at the S&P 500 going back to 1970, and I measured how stocks perform after they dropped 25 per cent. It has happened seven times. 

The following table shows the details. The first column shows the size of the drawdown, from peak to trough. The other columns show returns over one, three, five and ten years after the market dropped 25 per cent. Note that it’s not showing returns from the bottom of the trough — impossible to know in real-time — but from the point at which the market dropped 25 per cent.

Since 1970, investors who buy into bear markets have done well. They've been particularly well-rewarded in the following three years. 

In the following year after buying, returns are very mixed — in 2020, investors made 53 per cent in a year, but in 2009 they lost 9 per cent. That's because of course, a 25 per cent drop could either be a nice buying opportunity or the start of a major crash. You don't know at the time. Over the seven cases, the return averages out at 20 per cent.

Annual returns peak in the three years following a drawdown. Three years is close enough to the drop that the investor took some risk, but it's far enough away from it that the market had time to bottom out and recover. 

The outperformance fades over time. Over five years investors made 13 per cent per year, and over ten years investors made 9 per cent. And the average annual return on the US stock market since 1928 is 7.7 per cent, according to Macro Trends, a data provider. 

One takeaway from this is that it's smart to buy during a drawdown. Another might be that it's not smart to sell during a drawdown, as many do. Another might that it's not smart to buy when prices are racing up. But be careful with that last one — markets tend to hit all-time highs year after year after year. 

What would happen if you did the same exercise for bitcoin?

One last bubble?

The following comes with a health warning. Stock market returns are not like bitcoin returns. There is no long-term record of bitcoin returns. It's not impossible that we could be seeing the final deflation of the crypto bubble. Bitcoin might end up no more valuable than Beanie Babies.

Having said all that, and with a hat tip to Noah Smith who inspired it, here's a bitcoin chart. It's a logarithmic scale, which means it shows the change in percentages rather than absolute numbers. 

It shows returns that could have been made had you bought bitcoin after a 50 per cent drop from the all-time highs (because in crypto, a 25 per cent drop is a normal weekday) and managed to sell at the peak of the subsequent boom. 

There have been four bitcoin crashes and three recoveries so far. As you can see, the big money was made early on, when bitcoin traded for fractions of a cent. With each subsequent crash, and recovery, the returns dropped.

As it stands, bitcoin has fallen 75 per cent from its peak. It now trades at $16,423. If it has one more bubble in it, the log trend would suggest the upside is limited to somewhere in the region of $150 or $250k. If the bubble happened, and if you timed it just right, and sold at the perfect moment, it might be nice.

Or maybe crypto was a function of a frothy, speculative and silly time in finance, like Beanie Babies in 1999, and now we're back to Earth with a bang, and bitcoin is done.

The decision is never easy in the moment.