Is the sky falling?

One of the first stories I recall from my early childhood is the story of Chicken Little. Chicken Little is hit on the head by an acorn, decides the sky is falling, and she needs to tell the king. On the way to meet the king, she encounters Turkey Lurkey, Ducky Lucky, and a slew of other animals with rhyming names. Each animal is quickly convinced that the sky is indeed falling, and the crowd of animals grows as they journey to the king’s palace. At the end of the story it is revealed that the sky is not falling, and the animals had jumped to an erroneous conclusion.

As I write this in early September, the stock market has fallen for four consecutive months, with August’s decline being rather dramatic. Is the sky falling? Is it time to panic and run for the hills? Should we pay attention to the Eeyores (oops, wrong story) and sell all our stocks, buy gold and silver, and stock up on canned food?

The animals in the Chicken Little fable were very quick to jump to a conclusion based on scant evidence. When the crowd of animals got larger, it provided even more proof to the newcomers that reasoning and thinking were not necessary. It was time to panic, since everyone else was. Follow that herd. However, as the animals eventually learned, just because many others say something and say it loudly, it does not make it true.

Taking a longer time perspective will help give the recent market movements a more balanced perspective, which hopefully will lead to more intelligent investment decisions. Let’s go back further in time to see how dramatic this market decline really is. Let’s go back one year. I will use as a proxy for the U.S. stock market, the Vanguard total U.S. stock market exchange-traded fund, stock ticker symbol VTI. It is a broad-based investable security, unlike a market average, which you cannot invest in directly. From September 1, 2010 to August 31, 2011, the VTI has appreciated by 19%. This includes the last four months, when prices declined. But during the prior eight months, the market steadily rose. Over the course of the year, it rose about 2/3 of the time and fell 1/3 of the time, which, when measured monthly for a year, is rather typical. A 19% gain for a year is about twice the long-term average, so when examined this way, the current downturn is merely an adjustment to the faster-than-average rate of increase that preceded it.

But you might be thinking that one year is still too short a time frame on which to make a judgment, so let’s take an even broader perspective. Let’s try two-and-a-half years, which coincides with the rally from the market bottom in 2009. For the 2.5-year period from March 1, 2009 to August 31, 2011, the VTI is up 78%. This is a compound annual rate of 26% per year, which is far faster than the average rate of increase over much longer periods of time (more like 8-10%). So even with the recent downturn, the market is much higher than it was in the recent past.

One must be careful in jumping to conclusions, though. Let’s not make the same mistake Chicken Little did, but in reverse. We need to examine a time period which not only includes the recent downturn and the previous rally, but the market tumble of 2008 and early 2009. So let’s go back four years to the end of August 2007, which was right before the market peaked. Over the four-year period from September 1, 2007 to August 31, 2011, the VTI declined by a total of 7%. The annual rate of decline was less than 2% per year.

This exercise could be continued ad nauseam, but the overall conclusion would not change. By examining the most positive and the most negative cases, it bounds the experience. Just about all other samples will fall somewhere in between.

So what should be the conclusion that Foxy Loxy would come to? (Foxy Loxy never believed the Chicken Little story in the first place and plotted to take advantage of the other animals’ gullibility.) The market is lower than its most recent high, much higher than its not-quite-so-recent low, and a bit lower than its all-time high. To paraphrase another great storyteller, Charles Dickens, “It is neither the best of times nor the worst of times.”

It seems that the sky is still as high as it ever was.

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