Macro: Sandcastle economics
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The anatomy of Nasdaq 100 drawdowns and investor psychology
Peter Garnry
Chief Investment Strategist
Summary: The Nasdaq 100 is currently in its 15th largest drawdown since 1 January 2003 down 10.9%. History suggests that the drawdown could last 121 trading days if this is an average drawdown in terms of its recovery profile. This we think would profoundly alter investor psychology as the new group of retail investors arriving at equity markets last year have never experienced slow grinding equity markets for very long. Our thesis is that growth investing and its near term support will hinge on the drawdown length and thus is a key indicator to monitor going forward.
Nasdaq 100 is 15 trading sessions into the current drawdown down 10.9%and our bubble stocks basket is down 27.9% since the peak. Listening to many growth investors, both professional and retail, it has been a violent move, and many has been taken by surprise, or at least, many had underestimated the interest rate sensitivity and given it much thought. While painful for many investors we could see our bubble stocks basket experiencing a 50% drawdown taking the basket’s total return index back to levels from September last year – if this happens it would entail a 32% decline in bubble stocks from current levels. Outsized gains typically come with subsequent volatility and potentially dramatic drawdowns. That is the lesson of history, and this is no different.
Every drawdown has its unique cause and comparisons should be made with great caution, but when you face a drawdown of meaningful size you need to get your statistical prior right. The current drawdown is the 15th largest since 1 January 2003, so while it has felt dramatic to many investors it is still a benign correction. The median and mean drawdown length of these 15 drawdowns are 121 and 157 trading days respectively, so the current drawdown could extend for 6-9 months if this is an average drawdown.
What is important to investor psychology is the drawdown length. This was one of the main reasons retail investors left the equity market after the dot-com bubble burst. Investors are impatient people despite many argue they invest for the long term. The drawdown after the financial crisis in 2008 and the subsequent unemployment rate was also detriment for retail investor participation. Even has late into the current bull market as 2016 and 2017 you can find many articles on where the retail investor is in equity markets, and whether they will ever come back. There are also many mentioning of young people and women nor participating.
But the last couple of years bull market, improving labour market dynamics, a larger focus than ever by media on technology stocks, the rise of crypto and Tesla, have pulled many young people and women into the game of equity investing. Many arrived during the rebound phase last year when many people were forced into lockdowns. This means that a lot of the new marginal buyer of technology stocks have never seen a drawdown and not a drawdown of proper length. Therefore our thesis is that if this becomes a lengthy drawdown in technology stocks due to higher inflation and interest rates, then it will alter the investor psychology of growth investing and many will become impatient and shift strategies or maybe even leave the market. It is only really fun when returns come fast and easy.
The chart below shows the 15 drawdowns and their recovery profile. The blue line is the recovery after the Covid-19 pandemic started the historic sell-off last year. This is still the fastest recovery ever in history from such a large drawdown that reached 27.7% at the bottom and a recovery that took many quant strategies and tactical asset allocation strategies by surprise. The orange line is the current drawdown and something we will be monitoring for some time as it shapes investor psychology.
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