Dotcom Deja vu: warning signs before next crash

Anyhow, let’s see how severe the Dotcom bear market was by measuring some metrics like a recovery time and a maximum loss. The recovery time or drawdown duration was defined by a length of any peak to peak period. For the maximum loss or the maximum drawdown, it was simply the worst peak to trough loss since the investment’s inception. 
Furthermore, let’s assume that investors knew nothing that the Dotcom euphoria was about to end and invested right at the peak of the Nasdaq composite index around early March 2000. 
First, any veteran investors who went through post-Dotcom bear market would all agree that “Buy and Hold” won’t work. The Nasdaq composite endured a maximum drawdown of 70 per cent and took at least 14 years to reach its Dotcom peak. Similarly, the Asia ex Japan tech index (MSCI Asia ex. Japan information technology index or MXASJIT index) also faced 70 per cent loss and took roughly 13 years to reclaim its millennium glory. Surprisingly, the SET index tanked shallower (-32 per cent) and took a much shorter recovery time, only 4 years. But it was arguable that the SET index recovered faster due to the low-base (about 400 points) after a deep dive from the Asian financial crisis peak of almost 1700 points.
What’s about the dollar cost averaging (DCA) approach (Buying with exactly the same dollar amount every month)? By DCAing the NASDAQ composite, investors would have to endure negative return for about four years with the deepest return of –43 per cent . Likewise, those who applied DCA on the Asia ex. Japan tech index would have the largest drawdown about 45 per cent but only faced negative return period for almost two year. Interestingly, portfolios that DCA the SET index would only have a nightmare for about 1 year with 16 per cent maximum loss.
Clearly, DCA could greatly reduce the drawdown duration but this method succumbed to quite hefty drawdown (about 35 per cent on average) which could yield negative psychological impacts onto investors. Thus, investors could use a fix percentage stop loss like 8 per cent to limit the maximum downside. Nevertheless, to generate a buy or entry signal investors could use a technical signal as simple as moving average cross over. The buy signal will be triggered when price cross over 30-week moving average line while slope of the moving average is rising. Not only this simple system greatly reduced the maximum drawdown to 8-9 per cent but also significantly decreased investors’ painful periods to just below three year across three indices.
Besides above approaches, one could utilize various strategies in order to avoid a steep drawdown when the bubble burst. But solely investing in one stock index, investor will have to deal a severe impact if that index enters a bear market. To limit exposure to just one asset, investors should diversify their portfolio by investing in various asset classes according to his risk-adjusted asset allocation. 
For example, by investing 25 per cent in US stock (15 per cent in S&P500 index and 10 per cent in Russell 2000 index), 15 per cent in international stock (MSCI EAFE index), 10 per cent Emerging market stock (MSCI EM index), 10 per cent in REITs (FTSE NAREIT All Equity index) and 40 per cent in high-grade bonds (Barclay’s US Aggregate bond index), investors would spend less than three years of portfolio drawdown period with a maximum loss of 4 per cent.
Now the market’s rising momentum remains intact in near term, anyone could and should keep investing. Whether or not the history will repeat itself and the market will go down like the Dotcom sell-off, it is critically important for every investor, rookie or professional to be aware of the possibility of a meaningful correction. 

Second part of a two-part series. 
Views expressed in this article are those of the author and not necessarily of TMB Bank or its executives. Poon Panichpibool is Economic Specialist at TMB Analytics. He can be reached at [email protected]