Economic Commentary – What To Do If The Dow Drops 10,000 Points

Executive Summary

The war with Iran has driven the market down, and we wouldn’t be surprised to see the Dow drop 10,000 points. Not predicting that, just wouldn’t be surprised. Whether we swing into a correction or a significant bear market, or see a quick rebound, we should remember that a 10,000-point drop in the Dow is equivalent to a 20% move. We’ve had plenty of those before, survived them all, and then gone on to new heights of economic strength and market values. We remain confident in the resilience of the U.S. economy and ultimately in the future values of both the Dow and the S&P 500.

The S&P 500 and the Dow Jones Industrial Average are broad measures of the U.S. stock market. They move up and down, reflecting the general future direction of the U.S. economy. But there are times when they move simply in reaction to economic or geopolitical events that the markets did not anticipate. Currently, we are in the opening stages of a war with Iran, the start of which seems to have surprised the market. It is unclear whether the Dow is simply reacting to the surprise or predicting a period of significant economic contraction. Fortunately, in either case, we have a rich body of history to help us decide how to manage portfolios.

What Does A 10,000 – Or Even a 15,000 – Point Drop Really Mean?

The title of this blog post asks what to do if the Dow drops 10,000 points. We could just as easily have asked what to do if it drops 15,000 points. The answer would still be conceptually the same. A 10,000-point drop would represent a 20% drop, while a 15,000-point drop would represent a 30% drop. The points don’t matter; the percentage does. And we’ve seen drops of 20% and 30% before, recovered from them, and now only think of them as ancient history.

In other words, we’ve often seen the Dow drop significantly, and just as often seen it recover and then move even higher (see chart below). The Dow is resilient, and there is every reason to believe (even in the midst of a war with Iran) that this will continue to be the case.

We’ll thank our friends at First Trust for superimposing on this chart several significant economic or geopolitical events to give perspective on what was afoot in the world at each gyration, drop, or recovery.

The most obvious lesson to be drawn from this graphic is the historical normalcy of major negative events (or “black swans,” as some commentators like to call them). Whether the cause is an invasion, terrorist attack, currency crisis, natural disaster, or political resignations/impeachments, the common thread is that negative events happen and are usually a surprise.

Markets hate surprises because they disrupt the valuation calculations that are constantly used to assess the future direction of the economy and, behind that, the profit levels of all publicly traded companies. That is what the Dow and S&P, after all, are measuring – the profit levels of all these companies.

When these events occur, the market needs to assess the economic impact, but this reassessment usually takes time; out of a sense of conservatism, the market often drops quickly. Recoveries can occur in a matter of days or a couple of years, depending on the event’s long-term impact.

Many Years Are Both Up And Down

The S&P 500 chart below – again from First Trust – shows, year by year since 1980, the largest intra-year decline and the ultimate full-year return. For example, in 1980, the S&P 500 dropped 17% at one point, but it finished the year up 26%.

Recoveries and Reactions

If the market has been surprised, but that surprise is deemed unlikely to affect the economy significantly, then the recovery tends to occur within days. If, on the other hand, the economy is actually declining, the market recovery will come only as the economy recovers, which can take months to years.

But, the fact remains – as the first chart above shows – the crisis passes; the economy grows; recovery comes; and new highs are eventually attained. This begs the question that many investors always ask: “Should I move out of the market and then get back in when we’re back to normal?”

Interestingly, there is a way we can test this potential strategy. We can look at all the movements in the stock market across all trading days over a long period of time, then calculate what would happen if we pulled out of the market and failed to return at the right time.

The chart below covers the period from 12/31/1979 through 12/31/2024. There were 16,437 trading days over this 45-year period. Statistically, this is one of the largest studies we’ve seen. As the chart shows, if you had invested $10K in the S&P 500 and kept it invested over the entire period, you would have $1,708,147 at the end (12.1%/yr). But what would you have earned if you had tried the strategy of “moving out of the market and getting back in when we’re back to normal”?

The key to this strategy is getting back in at the right time. The chart shows the effect of missing the best trading days over the 45-year period. For example, if you missed the best 5 trading days, you would still have $1,059,083 at the end. Here’s a summary of the average returns based on what trading days you missed:

Invested in all trading days: 12.1% average annual return over 45 years.
Missed the best 5 days: 10.9% average annual return over 45 years.
Missed the best 10 days: 10.1% average annual return over 45 years.
Missed the best 30 days: 7.6% average annual return over 45 years.
Missed the best 50 days: 5.6% average annual return over 45 years.

To provide some perspective, 50 days represents 0.3% of the total number of trading days. For even more perspective, the average annual inflation rate over this period was 3.3%/yr. and the average return of U.S. Treasury bonds was 6%/yr.

If you try this get-out-now-get-back-when-it’s-normal-again” strategy and miss just .3% of the best days, the evidence is overwhelming that your rate of return would be only slightly above inflation and would be less than if you had just invested in Treasuries for the entire time.

That’s a 0.3% margin for error. Professional money managers aren’t that good, and they have reams of data and research to help them, let alone the hours they spend each day studying it. It is simply unrealistic – foolhardy, actually – to think that you’ll get this right. Success depends on remaining consistent and having long-term confidence in the recovery.

So, Should You Do Nothing?

Consistency and confidence are not the same as doing nothing. There are positive strategies to leverage downturns to improve financial results. Here’s a quick sampling of effective strategies; each reflects an attitude of consistency and confidence.

Rebalance into the downturn – Let’s use an example of a 50% stock / 50% bond portfolio. When the market drops significantly, your stocks will decline in value and represent a smaller share of the portfolio. Let’s assume that after the drop, your stocks represent 40% of the portfolio, which means your bonds now represent 60% of the portfolio. Rebalancing means selling bonds and buying stocks so the allocation returns to 50%/50%.

Here’s why it helps. Before the market drop, 50% of your portfolio was exposed to stocks, so the drop hit 50% of your portfolio. If you don’t rebalance, your stocks account for only 40% of the portfolio, so only 40% of the portfolio benefits from the recovery. If you rebalance, in our example, the full 50% of your portfolio will benefit from the recovery.

Harvest Tax Losses – If you have a significant portion of your portfolio in a taxable account (a non-retirement account), then this account will typically generate capital gains over the years, and you’ll have to pay capital gains taxes. Current federal capital gains tax rates are 15% and 20%. The law allows you to offset capital gains with capital losses in the previous year. Harvesting tax losses means purposely creating a tax loss during a market downturn so you can offset future capital gains taxes, and your after-tax return will improve.

Here’s why it helps. Imagine both Investor A and Investor B start the year with a $100,000 portfolio. During the year, they both sell a winning stock for a $20,000 gain. They also both happen to own a “dog” stock that is currently down $20,000.

Roth Conversions – If you have a traditional IRA or a traditional 401(k), a market drop is a perfect time to reduce your total lifetime taxes. By converting all or a portion of your IRA or 401(k) during the downturn, you reduce the taxable value and reinvest the money in a Roth, which is tax-free. As the Roth portfolio recovers and then grows, its value and future growth will be tax-free.

Here’s why it helps. If you have a $100,000 IRA, then when you withdraw the money during retirement (now or in later years), all of it will be taxable; and if we assume it will grow to $200,000 someday, then the entire $200,000 would be taxable.

But if the market downturn reduces your balance to $80,000 and you convert it to a Roth, then you pay income taxes only on $80,000. Right away, you’ve saved taxes on $20,000. But it gets better. If, in our example, it still grows to $200,000, the extra growth will be tax-free. That would be $120,000 of tax-free income.

Expedite Phase-In Strategies – Many clients use a phase-in strategy, which means they invest in the stock market on a monthly or quarterly basis. We find that the most common plan is to phase in over 3-4 quarters. If the market drops precipitously during the phase-in period, you can expedite one of the quarterly purchases to take advantage of lower-priced stocks, which will most likely then increase in value. You turn the downturn into a bargain sale of stocks.

Here’s why it helps. Let’s assume you plan to invest $1,000,000 in stocks over 4 quarters, adding $250,000 to the portfolio each quarter. If the market drops by 20% and you make one of these purchases during the downturn instead of waiting until the next quarter, you will get an extra 20% return on that purchase when the market recovers.

Stay Calm And Carry On

When the world goes topsy-turvy, it can be unnerving to say the least. As we write, the market is down, and it may go down further. It may be a short-term drop or a more protracted one. Whatever the direction of the next several moves, we have been here before and can draw solace and lessons from that history. One of our favorite maxims comes from the British WWII experience: “Stay calm and carry on.” That remains as true today, especially with investment portfolios, as it was almost a century ago. Remain consistent and confident, and, where possible, rebalance, harvest, and convert as appropriate to your specific situation.

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