The Investment Scientist

After deep sell-offs, follow sharp rallies?

Posted on: February 4, 2008

In the three month period between Oct 19th, 2007 and Jan 18th, 2008, the S&P 500 index fell 14.1% and the Russell 2000 Value Index fell 19.5%. To understand what is likely to happen next, I studied the top 10 worst three-month-sell-offs since 1950. These sell-offs ranged between -13% to -30%. I found that in 8 out of the 10 occasions, the S&P 500 index rebounded by more than 20% in one year. Small Cap Value stocks did even better. The Fama & French Small Cap Value Index rallied more than 30% in one year in 8 out of the 10 occasions. In the other two occasions, it increased 6.6% and 24.1% respectively. (See Table below.)

A market sell-off is not a risk

As Demonstrated by history, most of the worst market sell-offs were followed by a substantial rally within a year. Many investors panicked and fled to cash at the nadirs of the sell-offs. By the time they mustered enough courage to get back in, they had missed the rallies. If you want to achieve long-term investment success, treat a market sell-off as an opportunity, instead of a risk.

Table: One-year returns after the worst 3-month sell-offs

3-month period ending 3-month decline Subsequent S&P 500
12-month return
Subsequent Small Value
12-month return
Nov 1987 -30% 23% 32.7%
Sep 1974 -25% 38% 42.4%
Jun 1962 -21% 31% 37.9%
Jun 1970 -18% 42% 55.4%
Sep 2002 -17% 24% 41.4%
Sep 2001 -15% -20% 6.6%
May 1962 -14% 23% 30.6%
Oct 1990 -14% 34% 49.6%
Oct 1957 -13% 30% 50.5%
Nov 2000 -13% -12% 24.1%

Data sources: Fidelity MARE group, Prof. Kenneth French data library.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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