Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
The market is perched atop a sand dune next to the sea and waves are lapping at its base. There are some big storms on the horizon and it might not take much for it to collapse.
One storm is already inundating Greece, which is wrangling with its creditors as its economy sinks. Rarely have Aesop's grasshoppers been so eager to tweak the ants' noses. Call it a clash of cultures if you like, but both sides have been lessened by the experience and are likely to suffer from it.
The bickering in Europe can almost be heard in China, which is going through its own difficulties. But China is an economic dragon compared with Greece, and of far more importance globally.
The problem is, China's stock market crashed this week and only bounced back after authorities there embarked on a series of extraordinary interventions. Things were so bad that most of the country's shares were suspended from trading and large investors were ordered not to sell.
The heavy-handed move turns the Chinese stock market into something like the Eagles' Hotel California, where you can check out any time you like, but you can never leave.
With all of the unsettling news, it's time to take a peek over the edge and see what lies in wait for us in the depths below.
Today I'm going to focus on a simple, balanced portfolio and let history be my guide, the idea being to try to glean some wisdom by looking at past downturns from a Canadian perspective.
The balanced portfolio in question is composed of four basic building blocks that track broad market indexes. Canadian bonds are represented by the DEX Universe index and provide some stability. Canadian stocks and U.S. stocks are tracked by the S&P/TSX composite and S&P 500, respectively. They're joined by international stocks in the form of the MSCI EAFE index.
(The results below are presented in Canadian dollar terms, without currency hedging, and are based on month-end data with dividends reinvested. Raw index returns are shown, which don't include fees or taxes.)
The market has gone through many ups and downs along the way, but the biggest loser since 1980 was the S&P 500, which fell 51.2 per cent from its peak in 2000. The index didn't fully recover before the crash of 2008 and only climbed past its former high in 2013.
The second biggest loser was the MSCI EAFE index, which fell 46.6 per cent after reaching a high in 2007. It managed to recover six years later in 2013.
The S&P/TSX composite's largest decline was seen during the 2008 collapse, when it fell 43.4 per cent. But its longest downturn lasted for 4.8 years after it hit a Nortel-inspired high in 2000.
The biggest black eye for bonds came in 1994, when they declined 11.4 per cent. But they recovered the next year. Mind you, bonds have been in a long-term bull market since the early 1980s due to declining interest rates. Now that rates are very low, bonds probably won't do as well over the next couple of decades.
A portfolio with equal amounts invested in each index, rebalanced annually, fared relatively well. The portfolio's biggest decline was 31.1 per cent and its longest down period lasted 4.8 years. It also offered generous average annual returns of 10.3 per cent from 1980 through to the start of May this year. Along the way, it beat each of the indexes except the S&P 500, which climbed 11.6 per cent over the same period.
While this sort of retrospective provides an admittedly imperfect guide to what investors might expect from the next crash, it also offers some hope. After all, the market has a history of bouncing back to its old highs after only a few years – most of the time.
In addition, diversified portfolios often sail through storms in reasonably good shape. Sure, it can be hard to watch them slip underwater for a few years. But they'll likely emerge and grow again.
It's something to keep in mind when you're on the beach this summer and the storms come in.
Norman Rothery