How Bear Markets End And The Path Forward For Investors

view original post

honglouwawa

By Ryan Giannotto, CFA, Manager, Equity Index Research

No sane investor sets out intending to lose money – but when this outcome nonetheless transpires the experience can be psychologically racking for investors, novice and professional alike. Between the uncertainty and the relentless flashing of red that accentuates our loss aversion, one unifying theme often lost amidst downturns is that every U.S. bear market has ended. By examining over 40 years of bear markets, we can better turn towards understanding and knowledge rather than raw fear when selloffs strike.

The Anatomy of Losses

Despite their mythologized status as financial albatrosses, bear markets are relatively frequent and indeed normal occurrences investors should expect over the long run. For instance, U.S. equities have endured nine bear markets since 1980, meaning they have occurred on average every 4.5 years. Using the SEC’s definition of a 20% decline covering at least a two-month period, investors have been in bear markets 15.6% during this time horizon. Moreover, bear markets occur 50% more frequently than recessions. While perhaps unnerving, this mental reframe helps investors see bear markets not as cataclysms, but routine phases in the long-term returns of capital markets.

Using the Russell 3000 to calculate performance, the average drawdown and duration is 30.9% and 9 months, respectively. These averages, however, are not reflective of any individual bear market on record as the data follow barbell distribution along dimensions of both depth and duration. In other words, market declines tend to be either short (approximately 3 months), or much longer (approximately 20 months), with no middle ground; there is no middle ground. This same phenomenon presents itself sell-off intensity, where market declines cluster either at almost precisely 20% losses or at much more severe levels of a one third loss or more.

Four Bears: Polar, Grizzly, Black and Brown

Graphically, this empty centre is distinctive and lends us four archetypical models for bear markets, namely short and shallow, short and deep, long and shallow and long and deep (we will profile these as black, Grizzly, brown and polar bears, respectively). While it this latter profile that everyone fears, it is important to note they constitute only slightly more than one fifth of bear markets over this period, and they reflect systemic market failure or massive economic disequilibria. The Dot com crash and the Great Financial Crisis, witnessing 47.4% and 55.7% drawdowns respectively, are quite differentiated not only by quantitative characteristics, but the nature of their causes; polar bears truly are in a league of their own and can give asset prices a real mauling.

By means of contrast, the short and shallow bear markets are the most numerous type representing one-third of all declines. These black bear markets are strikingly consistent in behaviour, uniformly at 3 months in length and just surpassing a 20% decline. Composed of the 1990, 1998 Russian default/EM crisis and the 2018 December crash (where Powell notoriously exclaimed the Fed was contracting on “autopilot” in his first press conference) black bear markets are more akin to an aggressive correction than their polar bear brethren.

On the short and deep front, the archetype Grizzly bear includes the Covid crash and the 1987 portfolio insurance crash (yes, algos have long distorted markets – then crudely, now exquisitely). With downdraws of 35.0% and 33.1% respectively, these short-term events feature exotic causes that essentially blindside the market but nonetheless undergo rapid repricing. Finally, in the long and shallow brown bear category is the 1980 Volker decline, an extended 20.5-month affair where markets grappled with a transition in inflation and interest rate policy – not too dissimilar from our present environment.

The Bear Minimum: Where are we Now and the Path Forward

With a 24.1% drawdown in 5.5 months, the 2022 H1 bear market does not fit cleanly into any of these four profiles. While most similar to the short and shallow black bear archetype, the most recent decline was longer and deeper than this “correction plus” model. The chart below illustrates that, the Covid and 1987 crashes excepted, bear markets do not see wealth vaporise overnight but instead are somewhat protracted affairs with numerous counter rallies; there is time and opportunity to avoid rash decision making.

The most psychologically punishing aspect of a bear market is, however, not the losses themselves but the potential to miss out on an ensuing recovery. Bears do indeed bounce; some of the best returns in financial history follow bear markets, and forgoing these opportunities can be devastating. For instance, the Russell 3000 rallied up to 18.5% from its June 16th low, a 58% retracement, within a span of 40 trading days; this rate of recovery is 19 times higher than the long-term expected returns for equities.

As the first table depicts, time to recovery following a bear market has a median value of 92 trading days (average is 308 days), and these upswings can be tremendous. The rightmost column shows the annualized rates of return during historical recovery phases, which reached 99.3% and 132% for median and average rates of return, respectively.

When considering bear markets, loss aversion often dominates investor psychology, leaving the consequent rebounds underappreciated – indeed bear markets are small price to pay for a 68-fold increase in value over a 42-year history. This renewed perspective suggests that rather than rouse fear, perhaps bear markets should be regarded as harbingers for elevated return potential on the road ahead.

© 2022 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) FTSE Fixed Income Europe Limited (“FTSE FI Europe”), (5) FTSE Fixed Income LLC (“FTSE FI”), (6) The Yield Book Inc (“YB”) and (7) Beyond Ratings S.A.S. (“BR”). All rights reserved.

FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “FTSE4Good®”, “ICB®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.

All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided “as is” without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.

No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (A) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (B) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.

No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset or whether such investment creates any legal or compliance risks for the investor. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset nor confirmation that any particular investor may lawfully buy, sell or hold the asset or an index containing the asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB, BR and/or their respective licensors.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.