Why Stock Market Declines are Good

James Bullard, the St Louis Fed President, gave an interview today discussing how the stock correction has been good because it has helped to prevent a bubble. He’s inferring that lower prices are bad in the short-term and good in the long-term.  And he’s totally right.  I’ll show you why.

What happens when the stock market booms is that future returns get pulled into the present. Stock bubbles are dangerous because they pull so much of that future return into the present that they create an abnormal amount of temporal balance sheet instability. I’ve referred to this pricing change as a “price compression” in my book and elsewhere.  It’s a fairly simple concept and can help us understand what happens to prices in the short-term relative to the long-term. In essence, when prices boom in the short-term we pull future returns into the present which often reduces future returns. For instance, imagine a zero coupon bond like a Treasury Bill yielding, for fun, 3%.¹ This Bill will sell at $97.09 and will mature at par plus your 3% in 1 year.

Now, imagine that interest rates shoot higher to 6% right after you buy this Bill.  The price of your Bill will fall to $94.34 for a 2.83% loss. But that’s just a short-term unrealized loss and not necessarily a realized loss. After all, if you hold the Bill for 1 year you will still get your $100 plus 3% in interest.

So, what’s happening here?  The price of the Bill has compressed as the market environment changed.  Had you purchased another Bill immediately after the price decline you would have earned 5.99% on the second Bill. If you’d doubled down on the first Bill you would have earned an average return of 4.49% on both Bills thereby increasing your average return.  The price decline was bad in the short-term, but it was good in the long-term!  In other words, as prices compress positively (think bull market) in the short-term they tend to pull future returns into the present thereby lowering future returns, whereas, when prices compress negatively (think, bear market), they push future returns higher.

Stocks, while not perfectly analogous to bonds, are essentially coupon paying financial instruments. For instance, rolling mutli-year dividend payments from corporate America have been remarkably stable throughout history.² Now, the problem with the stock market is that the stock market has a very long and relatively imprecise duration³, but by my calculations it’s about 25 years at present. Of course, most people don’t have that kind of patience.  But with a bit of clever analysis it’s not hard to build an asset allocation model that reduces that duration by mixing fixed income instruments with stocks making all of this much more precise. And in doing so, you’re essentially capturing that price compression concept in a very intelligent manner by realizing a few things:

1. Price declines are bad in the short-term, but good in the long-term.
2. Buying dips isn’t just for market timers. It’s for the savvy asset allocator who realizes that price declines will tend to boost future returns.
3. The trick is making sure the duration of your asset allocation matches your overall investment time horizon!
4. The problem with most of today’s stock market asset allocators is that they spend too much time judging a 25 year instrument inside of a short-term time horizon thereby resulting in faulty analysis, excessive activity and all sorts of behavioral biases that reduce future returns.

¹ – I know, I shouldn’t technically call a T-Bill a zero coupon bond, but that’s essentially what it is.   And yes, 3% yielding T-Bills were the golden days!  

² – See Robert Shiller in “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?“

³ – I like to think of Corporate America as one aggregate living entity. It doesn’t die. It just evolves over time and shifts a growing pool of profits from one legal entity to another to another (usually changing names or getting gobbled up over time) all adding up to higher profits in the aggregate, in the long-run.