Market Factors: The four tiers of market fear

RBC Capital Markets head of U.S. equity strategist Lori Calvasina offered a useful template last week with Four Tiers of Fear in Modern US Equity Markets . Investors can use the format as a guide to how far markets will fall during any upcoming sell-offs.

The first Tier of Fear is the garden variety pullback. This involves a drop of between five and ten per cent for the S&P 500 and it’s the most common type of drawdown during the past three years. Ms. Calvasina writes that this is the “natural starting point for thinking about downside risk whenever a major source of uncertainty arises.”

Tier two is the growth scare, when investors endure a 14 to 20 per cent downdraft in the U.S. benchmark. There have been four of these since 2010 and in each case the market discounted a crisis or recession that never happened. The sell-off this year between February and April falls into this category.

Tier three is recession and war. On these unfortunate occasions the market declines by 27 to 32 per cent. The long history of U.S. recessions leaves a wide range of potential sell-offs – between 14 per cent and 57 per cent.

Recent war activity has caused consistent market declines of 20 to 25 per cent. This encompasses 9/11 and the subsequent war on terror, the two Persian Gulf wars and Russia’s invasion of the Ukraine. In the latter case, the S&P 500 fell 25 per cent.

Tier of Fear four is the calamitous major crisis. These involve painful equity market declines of roughly 50 per cent. Only three incidences in the past century qualify – World War II (equity benchmark fell 43 per cent), the tech bubble implosion (49 per cent) and the great financial crisis (57 per cent).

Ms. Calvasina’s template can provide valuable perspective for investors. Everyone gets a bit twitchy when the market falls off quickly but the characteristics of each of the four tiers potentially allow investors to predict the degree of the downside. For instance, if there is little or no risk of recession, the sell-off is almost certain to be a garden variety pullback and thus likely limited to 10 per cent downside. An actual recession implies that the benchmark may not stop falling until 30 per cent of its value has vaporized.

Investors should remember that the tiers are based on average results and there is significant potential variance in each of the four tiers. Nonetheless, to the extent to which the template motivates investors to examine the characteristics of any sell-off, it is a productive exercise.