ETF Complete Strategy Insights: Drawdowns (Part 2)

James Kimball | September 8, 2019

The ETF Complete model closed the week down -1.0% compared to the SPY which closed up +1.9%.

The SPY put in a strong finish to the week, closing decidedly above the 50-Day moving average for the first time in nearly a month on fresh optimism for a resolution of the trade tensions between the U.S. and China.

Stay tuned for the daily updates and log into the website to see holdings and additional performance data.

image

This Week's Strategy Lesson: Drawdowns (Part 2)

image

Last week we started a series on drawdowns. Whether they are caused by some global economic force or just random fluctuation, drawdowns are a part of life in anything uncertain business. Of course, not all drawdowns are created equally. Some are small and relatively painless while others can shake you out of trades or even the market. This week we are going to broaden our perspective on drawdowns by looking at how they play out in a handful of trending and big-name stocks.

Drawdown: Quick Review

A drawdown occurs when your equity goes from putting in a new high to moving off of those highs. Ultimately, we cannot know what the maximum of any drawdown is until the equity proceeds to put in a brand new high. It can be very helpful to look at an illustration.

image

In the example above, the equity puts in a new “peak” high at $1,200 in July. Over the next couple of months, the equity sells off down to about $1,050. This happens to be the lowest it sells off to before it puts in a new high a year later, but we cannot declare that low as the maximum “peak-to-trough” drawdown until we see it put in that new high. The time to recovery is simply the length of time between when the equity puts in a peak high and then finally puts in a new high.

The frequency and severity of drawdowns can play a big role in how hard or easy it is to stick with a trading system. Frequent, deep drawdowns can test your resolve to stick with a longer-run winning system. Expectations also play a roll. If you go into a trade expecting a particular or high level of volatility, you can risk and position-size accordingly and stay with the plan.

Drawdowns in Popular and Trending Stocks

The main issue with drawdowns is you never know for certain how far they will go down and when or if they will ever go back up. There might be a reasonable expectation that when a previously profitable and well-run company hits a snag, it will eventually be able to right itself, but there are no guarantees.

Drawdowns present us with the same old “fear” vs “greed” conundrum. The main fear is that stock will keep going down and you could lose significant capital. On the other side, if you sell now, you might take a loss and miss out on any potential upside should the stock bounce back.

Apple, Amazon, and Netflix have been some of the strongest stocks over the last couple decades. These companies have pioneered new technologies, products and services that have defined modern technology, entertainment, and commerce—and they have all been well rewarded by the market with huge price and capital appreciation over that same period.

Even still, holding these stocks is not always a picnic. In addition to their wild returns, they also have wild volatility and drawdowns. Netflix wasn’t around for the dot-com bust in the early 2000’s, but Apple had a -81% drawdown and Amazon was down -94% during that period. In the 2008-2009 financial crisis, Apple was down -59%, Netflix was down -51%, and Amazon was down -65%.

And you don’t just need a financial crisis to see this volatility. In recent years, even as these tech giants have been pushing to new all-time highs, we have seen some serious corrections. Just last fall, AMZN had a -34% drawdown, AAPL had a -39% drawdown, and Netflix topped out with a -44% drawdown.

image

While 2017 and the start of 2018 was fairly quiet, you can see from the chart above that these stocks are not immune to large and frequent swings and drawdowns—regardless of the broader market conditions.

Part of the risk-return trade-off is that stocks with more upside typically will also come with more downside. The trick is in trying to find the right trading instrument that matches your own risk profile and then matching your expectations and trading to maximize your chances for success.

As we have seen here, whether you are trading a quantitative model or individual stocks, drawdowns and how we handle and anticipate them are a part of trading. Next week we will wrap up this serious with a more in-depth look at the historical drawdowns and characteristics of the ETF models.