J.P. Morgan

EOTM: Special Edition

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4 EYE ON THE MARKET • J.P. MORGAN E y e o n t h e M a r k e t J . P . M O R G A N Falling from grace: catastrophic losses on Russell 3000 companies The prior section looks at stocks that were deleted from the S&P 500. However, the "distress" rate of individual stocks is higher than the index deletion rate, since there are stocks that suffer substantial price declines from which they do not recover, irrespective of whether they remain in an index. And what about small and mid cap stocks which are not captured by the S&P 500? To broaden our analysis, we analyzed all stocks that were members of the Russell 3000 at any time from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined what we believe a concentrated stock holder would see as a catastrophic loss: "a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from the peak is 60% or more." How often does this take place? As shown in the table, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are not talking about temporary declines during the tech boom-bust or during the financial crisis, but large, permanent declines that were not subsequently recovered. Technology, Telecom, Energy and Consumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of Health Care) and Metals & Mining (part of Materials) had loss rates over 50%. When do such catastrophic declines happen? The next chart shows the percentage of companies at any given time experiencing a catastrophic loss. These loss rates tend to rise during recessions and market corrections, but there's a steady pace of distress even during economic expansions. I don't think we should draw too many conclusions from the decline in loss rates in 2010-2013; they have been dampened by the longest and largest monetary experiment in the history of the Federal Reserve, during which time the real cost of money has been negative for more than 5 years. There is also a natural tailing off at the end of the chart, given that there is less time for companies to fail. Sector All sectors 40% Consumer Discretionary 43% Consumer Staples 26% Energy 47% Materials 34% Industrials 35% Health Care 42% Financials 25% Information Technology 57% Telecommunication Services 51% Utilities 13% Source: FactSet, J.P. Morgan Asset Management. Total % of companies experiencing "catastrophic loss", 1980 - 2014 0% 5% 10% 15% 20% 1980 1985 1990 1995 2000 2005 2010 Source: FactSet. J.P. Morgan Asset Management. Catastrophic loss rates on Russell 3000 companies % of com panies in the process of suffering a catastrophic, unrecovered loss of 70% or m ore Around 40% of all stocks experienced catastrophic declines, when defined as a 70% decline from peak value with minimal recovery. This is a subjective cutoff point; many concentrated holders would see smaller permanent declines as equally unacceptable, and whose risk should be mitigated. The outcomes based on a variety of thresholds suggest that for many concentrated holders, diversification should be a central part of wealth management planning. The Russell 3000 Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market. It is reconstituted annually to ensure that new and growing companies are reflected. 4

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