Beware the Falling Market Knife


A global share market rout is not your everyday event.

Japanese share investors have witnessed firsthand — albeit over two decades — what a 80+% collapse looks and feels like. This was death by a thousand cuts. Down, up, sideways, down — it was a long and head-scrambling path to financial oblivion.

The Great Depression correction took place over a three year period. You can see it on the charts, but we really can’t comprehend what it was like to live that nightmare on a daily basis.

The fact we’ve never personally experienced a collapse of this magnitude is why we cannot fathom the prospect of it happening.

The past three decades have conditioned us to prosperity.

Share markets have risen 14-fold.

House prices (especially in Melbourne and Sydney) have risen by a similar multiple. The median income is $80,000 (according to latest ABS stats).

On average, we have bigger and better furnished homes. We travel more and enjoy the cafe lifestyle. Our expectations are much higher than in the 1980s.

This position of improved wealth is courtesy of the following: home equity loans, low doc lending, car loans, leases, margin debt, credit cards, 48 month interest free loans, payday advances, HECS debts.

The very commodity that has created our world of prosperity — debt — is the one now threatening to tear it asunder.

We’ve been conditioned for so many decades to believe the world functions in a certain way. For 30-plus years, debt has been our servant. But what happens if debt suddenly and violently turns on its master?

Prosperity turns into poverty.

Should this be the case, the world as we know it would become unrecognisable. All our preconceived notions on how markets should react (based our recent experiences) will be challenged.

The major market corrections in recent history — 1987, 2000 and 2008 — have taught us three things:

  1. Markets do fall 50+% in value
  2. Markets eventually stage a recovery (and in the case of the US, they recover to new highs)
  3. You can count on one hand the number of institutional economists or analysts who predicted the major correction.

Starting with the last point first, forget about receiving any advance warning of an imminent market catastrophe from the mainstream.

It simply is not in their best interests to present a ‘what if’ scenario. You have to do your own homework and decide whether markets are on stable or precarious grounds.

As for the other two points, we’ve learnt markets can be tough but also forgiving. This is the lesson from recent corrections. It’s this experience that frames our thinking on what may happen the next time the market does a ‘dummy spit’.

But ‘what if’ the next downturn is a one in 100 year event?

‘What if’ the market turns brutal and unforgiving? We may well see a dark side of the market for which we are psychologically unprepared.

In the first part of this week’s Daily Reckonings, the historical and mathematical cases for a potential seismic downturn were presented for your consideration. Naturally, this doomsday scenario was dismissed as a fantasy of my destructive thinking.

Yesterday was the reasoning behind my investment motto of ‘winning by not losing’. The deeper the fall, the steeper the climb to recovery.

A loss of 90% requires a gain of 900% just to break even. Those kinds of returns do not come every day. They take decades to accumulate.

It doesn’t take too many brain cells to figure out that avoiding the devastating loss in the first place would be the preferred outcome.

The difficulty with ‘stepping to one side’ is that we don’t know when the next substantial correction will come. You could be missing out on further gains by waiting in cash.

Hence, the need for share exposure based on your tolerance for losses.

This approach to asset allocation puts you in the driver’s seat.

Assuming you manage to sidestep the worst of a catastrophic market downturn, how do you participate in the recovery?

In the midst of market panic, how do you know when to buy? You’re nervous and wondering if the market could fall further. Fear does funny things to your judgment.

This dilemma of when to buy into a falling market is why a market sage coined the term ‘don’t try catching a falling knife’.

Catching a falling knife, investing in a down market


Not knowing when the knife is going to hit the floor makes buying into a falling market risky business.

Conventional wisdom is a 50% correction would be a screaming buy. You’ll have the chance to buy two shares for the price of one.

But what if the 50% correction is a whistle stop on the way to a 90% correction?

The following table shows the losses that would be incurred depending upon when you buy into the correction (assuming a 90% correction):

Buy in when market corrects

% loss if market falls 90% in value









To assist in understanding the chart, let’s say the market starts at 100 points.

A 50% correction would take it to 50 points. If the market falls 90%, it would devalue to 10 points. This is a 40 point (or 80%) loss on your buy in level.

Catching this falling knife would nearly sever an artery.

The other point to note in the imperfect science of how best to take advantage of a depressed market is that markets do not fall in a straight line.

It could take years for the market to zig and zag its way to exhaustion, as we’ve seen with The Great Depression and Japanese examples.

This is where long term valuation tools and market sentiment indicators — Shiller P/E 10, Tobin Q, Market Cap/GDP ratio, Advisor Sentiment readings, VIX, etc. — are useful in determining whether markets offer sufficient discount to warrant investment.

While the math may be giving you the green light, you must recognise that in a market meltdown fear could well drive valuations to obscenely low levels.

How do you catch the falling knife in this scenario? Little by little.

The only way to buy into a market lurching from new low to new low is progressively.

Have a pre-determined dollar cost average strategy. Work out how much each week, month or quarter you’ll systematically invest into the heavily discounted market.

Easing your way into a deeply discounted market provides you with the best opportunity to minimise your downside and maximise your upside.

This is the strategy Gowdie Family Wealth will be employing when the market signals it’s time to swap cash for absurdly cheap equities.

In the meantime, a great deal of patience is required.

Vern Gowdie
For The Daily Reckoning Australia

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Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.

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3 Comments on "Beware the Falling Market Knife"

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slewie the pi-rat
slewie the pi-rat
2 years 2 months ago
well, things looks screwed down pretty tight to me. and they have for quite some time, going well into three years now. the logic here is not a problem. i sure don’t care for “markets” here, either… but what “should be” happening is not happening. and three years is not nothing. i wouldn’t mind a giant cash sale on just about everything. but there’s a lot of cash, still. “credit events” seem to be playing out, here and there, but the bear has not gotten too riled up. yet. no cascading margin calls. yet. the checks are in the mail.… Read more »
2 years 2 months ago
Vern, You don’t ever seem to mention Stop Losses on your investments. You talk about a 90% correction as if everyone who has any money in stocks is going to lose that amount during your hypothetical crash. All investors should have disciplined Stops in place and learn to execute them no matter what. It’s very painful to do so, and it can hurt when you lose the full amount of initial stop(say 25%), but then your on the sidelines with Vern and watching the crash. No one who is disciplined and keeping an eye on trailing stops should ever cop… Read more »
2 years 2 months ago

This current peak oil induced global financial crisis has only just started. Economic growth is a surplus energy equation. There will be no recovery.

Modern agriculture is the process of turning fossil fuels into food. Population reduction is going to happen whether we like it or not and it won’t be pretty.

Worrying about the market is distracting from more serious issues. DR will disappear and history will not remember it.

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