Among the most frequent questions we receive from investors are those that involve market downturns:
The concern is understandable in light of the severity of the market decline during the 2008 financial crisis and the long period of mostly positive returns that has elapsed since then.
Although the investment profession has no shortage of people who claim to know the answers to the questions around the timing and depth of the next downturn, the available evidence tells us that very few people are able to accurately forecast market turns and that most who attempt to do so underperform in the long run. Therefore, we choose to focus on the latter two issues, portfolio impact and managing through a downturn, as those areas can be better controlled by the investor.
We begin by examining historical market downturns to gain some context on what they have looked like. We then consider how best to approach a potential downturn based on an investor’s time horizon.
A market correction is defined as a decline of 10% or greater from the market’s most recent high. A bear market is a more severe type of correction with a peak to trough decline of 20% or greater.
In general, the return on the S&P 500 index is used as a barometer for measuring the severity of downturns. However, since different parts of the stock market move in different ways, a correction or bear market may not necessarily apply to the entire stock market at a given point in time. For example, if small cap stocks decline 20% and large cap stocks decline 15%, the former has reached bear market status, while the latter has experienced a correction.
Since the end of World War II, the S&P 500 has experienced 42 corrections, 11 of which have qualified as bear markets.1 The median overall length of a correction has been 100 days, while the median length of a full-fledged bear market has been 363 days. The longest downdraft was the bear market that followed the bursting of the dot com bubble, which lasted 929 days spanning 2000 to 2002.
The median correction resulted in a drawdown of -14.7%, while the median bear market drawdown was -27.1%. The largest drawdown was -56.8%, which occurred during the financial crisis of late 2007 to early 2009.
It is interesting to note that the frequency of both market corrections and bear markets has declined. If we divide the post-war period into two equal halves, the first half witnessed 26 of the 42 corrections and 8 of the 11 bear markets. This period culminated in the early 1980s bear market, which produced a drop of 27.1% as Paul Volcker’s Federal Reserve aggressively raised interest rates to choke out inflation.
Since that time, there have only been 3 bear markets. However, they have been among the more violent. The two most recent of these (2000-2002 and 2007-2009) produced the worst outcomes of the entire measurement period with peak to trough losses of 49.1% and 56.8%, respectively. The third bear market during this period was also notable, as the majority of its loss occurred on a single day, the Black Monday crash of October 19, 1987.
It is difficult to know why the frequency and nature of corrections has evolved the way it has. One possibility is greater influence from monetary policy in recent decades. The Alan Greenspan-led Federal Reserve in particular was noted for aggressively keeping policy rates low, and the subsequent regimes of Bernanke and Yellen were similarly noted for their relatively loose policy. This may have resulted in more protracted economic expansions and bull markets, and subsequently, more violent unwinds of the associated market excesses. Regardless, it is impossible to forecast with certainty whether this trend will continue.
As daunting as some of the bear market statistics may seem, it is important to view them in the context of overall market performance. While there have been 11 bear markets in the post-war period, there have been 19 bull markets (defined as a gain of 20% or more from the most recent market low)2. Not only have bull markets been more frequent than bear markets, they have also lasted longer and produced a greater magnitude of return (Exhibit 1). The median length of a bull market has been 14 months, and the median return has been 51%. At more than 9 years in length, the most recent bull market is both the longest and the largest, with a cumulative total return exceeding 300%.
The above shows that the general long-term trend of the stock market is decidedly higher. In fact, since 1950, the number of days the S&P 500 has spent moving toward a peak from a trough is roughly 2.5 times higher than the number of days it has spent moving in the other direction.3
Most individuals and institutions have an investing horizon that spans more than just a few years. Thus, while it is always possible that a correction or bear market could produce near-term losses, it is critical to understand that those losses do not become permanent unless the investor is forced to sell or elects to sell at an inopportune time. Otherwise the broader upward trend of the stock market has eventually rewarded long-term investors by overpowering the negative returns in every case.
In the 73 calendar years since the end of World War II, the S&P 500 total return, defined as the price return plus dividends paid, has been positive 57 times and negative 16 times.4 Over that timeframe, there have been 71 distinct 3-year periods (1946-1948, 1947-1949, etc.). The return has been negative in just 8 of those. As the time horizon is increased, the incidence and severity of negative periods continues to decrease (Exhibit 2). There have been no instances of negative returns over any 15 or 20-year time frame. Interestingly, while the length of the current bull market may give pause to some investors, the 20-year period ending in 2018 is actually the worst 20-year period the market has experienced in the post-war era. This is driven by the inclusion of 1999-2008 at the beginning of the measurement period, a time frame which picks up the negative results from the two most recent and extreme bear markets.
Investors with shorter time horizons have more potential exposure to the negative impact of a bear market. This may include investors who require material withdrawals from their portfolios in retirement or those who have a specific time-based goal such as funding a college education. In these cases, it is important to construct an asset allocation plan that balances the desire for competitive returns against the need for shorter-term stability. The plan should include a target overall split between stocks and bonds and should address the degree of risk that is acceptable within the stock component (e.g. how much large-cap, small-cap, emerging markets, etc.).
One way to arrive at an acceptable risk level is to assess the potential impact of a large downturn on the portfolio’s value and determine what portion of that decline could be absorbed without materially jeopardizing the investor’s goals. For example, if an investor with a 3-year horizon assumes an extreme downside case of -30% for stocks and wants to limit the portfolio’s downside to -10% in conjunction with a specific goal, the portfolio’s bond allocation can be increased until it becomes highly likely that the investor’s loss threshold will not be exceeded. This approach allows the investor to participate in any stock market gains while still limiting near-term risk to an acceptable level.
Investors who are concerned about a possible bear market often ask why it wouldn’t be a better idea to position the portfolio extremely defensively, wait for the downturn to run its course, and then plow back into the market at lower prices. Of course, if people were consistently able to actively and correctly time the market in this way, it would be the exact right way to invest. Unfortunately, the track record for this actually working in practice is dismal. A closer examination of market timing can be found in our piece entitled "Does Active Management Win in Down Markets, and Does it Even Matter?", but the overwhelming evidence is that it simply does not work, and that keeping a long-term focus through downturns is a far superior approach.
This leads to a final point to remember. Investors in a stock ETF or mutual fund essentially own tiny pieces of hundreds of companies. They are not merely fund owners. They are business owners. Most successful business owners take a long-term view, prudently managing through economic rough patches and perhaps even investing more in the business to better position it for the eventual rebound. And like smart business owners, smart investors may be able to profit at the expense of their more short-sighted competitors. Viewing the portfolio in this way may help to mitigate some of the fear and uncertainty that accompanies market downturns.
Notes:1 Bear market and market correction data sourced from Yardeni Research, Inc.
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