Tune Out the Noise: How Do World Events Affect the Stock Market?
With volatility in global equity markets, and current news events, it's reasonable to wonder how this affects long-term equities returns. It's easy to quip "zoom out" or "tune out the noise", but we can also analyze past data and events to see just what happened during and after market corrections. So, let's do just that using the MSCI World index.
What Is MSCI World?
MSCI World is an index. It covers global mid- and large-caps. It's not a perfect proxy for global equities (it currently has about 85% of the free float coverage by country). But it's something that I can easily get a large amount of historical data for.
We're going to be pricing MSCI World in USD, unfortunately. I can't price this all the way back to the late 70s in CAD. This is not a huge problem as what I'm really trying to illustrate here is how equities markets respond to world events and how they look over the very long-term. "Good enough" applies here.
What Does a Typical Returns Chart Look Like?
Below is a graph of MSCI World from 1978 until roughly now. The challenge here is this chart is deceptive. Returns compound over time, right? That compounding effect makes it look like returns have accelerated as time goes on – that's not necessarily the case, though. And the compounding effect also means that the left hand side of the chart is missing important detail.
Did Somebody Call for Math?
Luckily, there's something fairly simple that we can do with math to make long-term returns better reflect the natural ups and downs of the market. We can use a log scale for the chart.
You can see now from the chart above that we've lost the "compression" of market movements on the left hand side of the chart. And historical events can now be easily seen. Talking of historical events...
Black Monday
I was in high school when Black Monday occurred. I still remember watching the news about it. I also remember checking stock prices in the back of the newspaper, but I digress.
"Black Monday (also known as Black Tuesday in some parts of the world due to time zone differences) was a global, severe and largely unexpected stock market crash on Monday, October 19, 1987. Worldwide losses were estimated at US$1.71 trillion. The severity of the crash sparked fears of extended economic instability or even a reprise of the Great Depression". (Source: Wikipedia)
Now that we've log-scaled our chart, you can actually see the Black Monday drop (highlighted with the red dash line). At the time this was a catastrophic event and there was talk of entering not just a recession, but a depression. But in hindsight it doesn't look like much more than a blip.
The Dotcom Bubble Burst
Between 1995 and 2000, the NASDAQ 100 rose around 400%. And then dropped 78% starting in 2000, cancelling out nearly all of the previous five years of gains.
U.S. equity returns after this crash colloquially became known as the "Lost Decade". Equity returns were so poor that buying a bond index would have outperformed.
During the Lost Decade, Canada would return ~73% and Emerging Markets would return ~150% - making a strong case for global diversification. Unfortunately, recency bias abounds and it's quite common to hear "the S&P 500 is the only investment you need". I would suggest you to look at the inflation-adjusted returns of the NASDAQ 100 in this post before considering doing that.
The Global Financial Crisis (GFC)
For those of you not quite as elderly as me, you might have the Global Financial Crisis on your radar – even if you weren't an investor back then.
The 2008 financial crisis, also known as the global financial crisis, was a major worldwide economic crisis, centered in the United States, which triggered the Great Recession of late 2007 to mid-2009, the most severe downturn since the Wall Street crash of 1929 and Great Depression. (Source: Wikipedia)
The Covid Crash
There is no doubt that the covid pandemic was a horrible and life-changing event for many of us.
It was no surprise that global equities markets took a significant hit. In retrospect, the stunning thing wasn't the drop – but how quickly markets reverted to mean. We don't know how quickly markets will revert to the mean – but history does tell us that they generally do.
Should You "Buy the Dip"?
It's your money and you're free to do with it what you like. But the effects of averaging down diminish based on your existing portfolio size and the size of the new investment.
You can read more about that here if you're interested in the math. But often, for an established portfolio, the effect size is small.
If you're a systematic investor (i.e. investing when you receive every paycheque) and you're buying a reasonable choice of asset, just keep on truckin'!
Tuning Out the Noise
So what do long-term returns look like on an index like MSCI World? Well, pretty decent.
I can't guarantee you'll get these returns. We're not clairvoyant, we can't predict the future. But there's also no reason to think that equities won't outperform the risk-free rate over a long enough time horizon.
The key here is time horizon and extracting a reasonable risk-adjusted premium. You do that through global diversification. Which also gives you a secondary benefit of holding many currencies indirectly (which can buffer you purchasing parity). At the end of the day, you're not a trader: you should look for a strategy that maximizes returns without undue risk. Life events such as paying for a child's education or retiring literally depend on understanding this risk-reward ratio.
One other thing you might learn from the chart is this: over very long time horizons, returns tend to centre around the mean. Many folks resist investing at all time highs: yet history teaches us that might be a mistake.
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The App
I created these charts with an app I built. You can play with the app, too! If you scroll the "brushes" at the bottom of the chart, you can not only zoom in on a period, but also see the compound annual growth (CAGR) for that period.
You'll also find a lot more events than the ones we've covered in this post. You can draw your own conclusions about how equities markets perform over the long term.
You can access the app here: https://noise.looniesandsense.com.
Final Thoughts
Drawdowns are going to happen in your lifetime. They may be short, sharp shocks. Or even extended periods where bonds outperform equities (such as U.S. equities during the Lost Decade). You get the equity risk premium for a reason.
If you're comfortable holding on for dear life, there's research that indicates that international diversification can deliver optimal life cycle (lifetime) returns. That paper is called "Beyond the Status Quo" by Cedarburg et al and has just received its third update.
For those who don't have the stomach for 100% equities for life, you can add less correlated diversifiers such as fixed income. For the more daring, there are more elaborate tail-risk strategies. But at the end of the day: you're generally giving up something (returns) to get something in return (less volatility).
I do want to remind you, again, that an investment life cycle can quite easily be 50-60 years. You don't stop being an investor when you retire. And that also means you really should zoom out a bit and tune out the noise!
I wish you Many Happy Returns.