- Bear markets are generally defined
as a peak to trough decline of at least 20%
in the stock market.
Bear markets are not fun to live through,
but they should be expected from time to time.
Every now and then uncertainty about the future
drives asset prices down,
and it usually feels like things are going to get worse
before they get better.
The U.S. stock market has had 27 bear markets
from 1900 through March 2020 by my count.
That works out to a bear market
every four and a half years on average.
Even for the most seasoned investor,
every bear market is equally unnerving.
Uncertainty is hard for us humans.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you why every bear market is different
and why that is not a reason
to abandon a properly diversified portfolio.
(bright music)
Investing in stocks is risky.
Risk is not a flaw in the stock market,
it is for taking on the risk of owning shares
in businesses that investors are able
to expect positive long term returns.
Investing in less risky assets like bonds is also an option,
but the expected returns are lower.
This risk-expected return trade off
is pervasive in investing.
From 1900 through 2019, global stocks delivered
a 5.2% annualized inflation adjusted return,
while global bonds delivered much more modest 2%
over the same time period.
That 3.2% annualized difference might not seem like much,
but over 30 years at those rates,
a stock portfolio would increase its purchasing power
2.5 times more than a bond portfolio.
Who wouldn't go for that?
Lots of people.
And I'll tell you why.
The challenge with investing in risky assets like stocks
is that despite their positive expected returns,
they tend to be volatile in the short term.
This can make sticking with a long term investment strategy
hard to do.
Richard Thaler and Shlomo Benartzi referred to this problem
as myopic loss aversion in a 1993 paper aptly titled,
Myopic Loss Aversion and the Equity Premium Puzzle.
They theorized that investors are loss averse,
meaning they're distinctly more sensitive
to losses than to gains,
and that they evaluate their portfolios frequently,
even if they have long term investment goals
such as saving for retirement.
Myopic loss aversion might be easier to live with
if we always knew how the story would end.
Enduring losses with the knowledge
that things will be better soon,
is a lot easier than living with the uncertainty
of a specific situation.
I can't tell you how the current bear market
or future bear markets will end.
Uncertainty is tricky like that.
But I can tell you how things have played out
after past bear markets and how uncertain things seemed
for investors at the time.
I'm using monthly U.S. stock market data
because Robert Shiller publishes it
on his website going back to 1871,
and you can download it there too.
Since 1900, the U.S. has had 27 bear markets.
On average the decline has been 30% from peak to trough,
and it has taken 13 months for that drop to happen.
From the bottom, it has taken on average,
27 months to return to the previous peak.
I think it's easy to see those data and think,
hey, that's not so bad.
I can handle a 30% drop over 13 months
and a 27 month recovery.
If only it were that easy.
When a market drop is happening,
you don't get to see where the bottom is.
And in most cases, there's a lot of reason to believe
that things will not get better.
Here's some past bear markets with what I think
are particularly unnerving causes.
During the Panic of 1907,
the U.S. stock market dropped 36% over 14 months.
Preceding the drop, the U.S. had been devastated
by the San Francisco earthquake and fire of 1906.
The economic fallout of the earthquake
pushed the U.S. economy into a recession in May 1907.
And soon after that the financial sector crashed.
Banks collapsed, including the Knickerbocker Trust Company,
which was one of the largest banking institutions
at the time.
A massive natural disaster, macro economic troubles
and a domestic financial crisis,
that doesn't sound like a good time.
It's easy to look back now and see
that the market bottomed out by October 1907
and recovered by July 1909.
But without having that knowledge,
enduring the drop would have been challenging.
Moving ahead a few years, the New York Stock Exchange
had closed for an unprecedented four months in 1914
to avoid a financial crisis due to the war.
Talk about uncertain times.
After the reopening of the exchange,
the U.S. market rose to a new peak in October 1916.
In late 1917, a nasty flu now known as the Spanish flu,
was sweeping through U.S. military camps.
The virus rapidly spread across the globe,
probably through the movement of troops during
and after World War I.
Around the same time as the first reported cases of the flu,
the U.S. stock market took a steep dive,
dropping a little more than 30%
from the October 1916 peak to the trough in November 1917.
If we account for inflation,
which was quite high at the time,
that drop in real terms was closer to 45%.
The 1918 flu pandemic had a huge economic impact globally,
reducing GDP by an estimated six to 8% in a typical country,
as interventions similar to those that we are seeing
today were put in place, restricting economic activity.
It seems likely that the combination
of public health concerns and economic uncertainty
made this a challenging time to stay invested.
Nobody knew when the bottom would come.
An interesting point here
is that while the worst of the Spanish Flu did not come
until later in 1918, the market had already started
its recovery by then.
The theoretical explanation for this might be that the worst
of the pandemic had already been priced
into the market in 1917.
Of course, nobody would have known that at the time.
Fast forward to 1929, after nearly a decade
of leveraged speculative investors driving up stock prices,
the stock market reached a peak in September 1929,
plummeted in October and was down 30% by November.
It continued to fall until June 1932,
when it reached a peak to trough decline of 83%.
During this massive decline in prices,
there was also a severe drought
that impacted the U.S. agricultural output,
significant deflation which discouraged spending
and global tariffs reducing trade.
U.S. unemployment reached 25%
and thousands of U.S. banks failed in the 1930s.
If economic hardship weren't enough,
Americans were watching as communism and fascism took hold
in other parts of the world,
no doubt raising concerns about the viability
of the American way of life.
The bottom came in June 1932,
33 months after the September 1929 peak,
but it wasn't a smooth ride back up.
If you had invested at the peak in September 1929,
you would have not recovered your initial investment
in nominal terms until June 1944, 15 years later.
Between 1932 and 1944, there were four other bear markets
with peak to trough declines of 30% in February 1933,
20% in October 1933, 20% in July 1934 and 50% in March 1938.
The 30s were not a fun time to invest in stocks.
I think it's worth mentioning
that it took 15 years to recover
from the 1929 stock market crash in nominal terms.
But this was a significantly deflationary period,
the price of goods was falling.
If we adjust for deflation,
the recovery came much more quickly,
in about seven years from the peak in September 1929.
A little over four years from the bottom in June 1932.
That's still a long time to recover,
but not nearly as daunting as 15 years.
The 1930s were particularly turbulent,
but we don't have to go far into the 1940s
to find our next bear market.
The market dropped 28% from its peak in September 1939
to its trough in April 1942.
This decline was punctuated by Hitler's invasion
of Western Europe in May 1940 and the Japanese attack
on Pearl Harbor in December 1941.
That's the kind of uncertainty that makes your head spin.
At least it makes mine spin.
I can't even imagine living, let alone investing
through that type of uncertainty.
Only nine months after the bottom,
the market was back up to its previous peak.
In September 1974, stocks fell 46%
from their December 1972 peak.
The U.S. economy had entered a recession in November 1973
and inflation was surging at the time.
That 46% drop in the stock market was closer to a 60% drop,
adjusted for inflation.
President Richard Nixon had taken historic economic measures
to combat inflation in 1971,
commonly referred to as the Nixon shock,
but they ended up failing.
Adding to inflationary pressures in 1973,
the Arab-Israeli war broke out,
resulting in the 1973 oil crisis.
By March 1974, the price of oil had risen nearly 400%.
27 months later, in December 1976,
the market returned to its 1972 peak.
More recently, we have had the tech bubble
with a peak in March 2000 and a trough in September 2002,
with a 45% peak to trough drop.
Maybe less intimidating in terms
of the associated uncertainty,
but at the very least the hopes and dreams
of temporarily wealthy technology investors were shaken.
The U.S. ended a recession in March 2001,
which lasted a year.
The recovery in the stock market took four years
from the September 2002 trough.
The great financial crisis started in October 2007,
with the stock market reaching a trough in February 2009,
down over 50% from its peak.
Loose lending and outright fraud
in the subprime mortgage market
had resulted in a precarious housing bubble
and a baking and liquidity crisis.
The crisis nearly resulted in the collapse
of the global financial system
and all of the civil unrest that could have come with that.
And it did result in the collapse of large
and historic U.S. institutions like Lehman Brothers.
Three years after the trough in February 2012,
the market was back to its October 2007 peak.
Alright, alright.
But the U.S. has had tremendous economic success.
I know that.
Maybe it isn't fair to cherry pick their data
to instill optimism in the stock market.
What about the elephant in the room, Japan.
Today, Japan is a third largest economy in the world.
In the 1980s, Japan was an economic powerhouse,
and its stock market was the largest in the world,
making up 45% of the world's
public equity market capitalization
by the start of the 1990s.
The USA made up 29% of the global market at that time.
The MSCI Japan index delivered an annualized return
of 22.4% from January 1970 through December 1989,
nearly double the return of the U.S. stock market
over the same time period.
Starting in early 1990, the Japanese economy began to stall,
and its stock market dropped 36% by the end of the year.
But here's the interesting part,
it never really came back to life.
From January 1990 through December 2019,
Japanese stocks have delivered an annualized
0.6% return before inflation.
At the time of the collapse, Japan had low interest rates,
high stock market and real estate valuations
and a heavy corporate debt load.
If that rings a bell, it should.
All of those characteristics could be used
to describe developed countries like Canada
and the United States today.
To combat their slowing economy and falling asset prices,
Japan used some of the economic policy initiatives
that we are seeing today, like quantitative easing
including the purchase of corporate bonds
and extremely low policy interest rates.
Comparing any situation to 1989 Japan is scary.
Japan had a market drop 30 years ago
that it has not recovered from today.
It's easy for the representativeness heuristic to kick in,
estimating the probability of an outcome
based on the outcome of a similar event.
If the developed world today it looks like Japan in 1989,
maybe this time really is different like it was for Japan.
When Kahneman and Tversky first described
the representativeness heuristic in their 1974 article,
Judgment Under Uncertainty, Heuristics and Biases,
they explained that this approach to the judgment
of probability leads to serious errors,
because similarity or representativeness
is not influenced by several factors
that should affect judgments of probability.
Put simply, assuming that the Japanese outcome
will be repeated based on some similarities
probably doesn't make sense,
especially considering that stock market
and economic forecasts are often wrong.
I don't think that the Japan story
is an argument against optimism,
it is instead an argument in favor of diversification.
And I don't just mean geographic diversification.
Over the same period that the Japanese stock market
returned 0.6% per year,
Japanese small cap value stocks returned 5.13% per year,
and Japanese market wide value stocks returned
4.04% per year.
I'm not saying that those are impressive returns,
but even over this period where the Japanese market
was flat for decades, value stocks delivered
an independent source of return.
This outcome is consistent with economic theory.
The same thing happened in the U.S. for the decade
from March 2000 through February 2010.
You lost money in the U.S. stock market
as a whole for a decade, while U.S. small cap value
and market wide value stocks delivered annualized returns
of 7.94% and 4.56% respectively.
You can't make this stuff up.
Global capitalism has been a triumph of human resilience,
perseverance and dynamism.
That doesn't mean that things won't change,
like Japan being the largest stock market
in the world in 1989 or the UK being the largest in 1899.
Some markets will decline permanently
or at least for extended periods of time,
as well some industries and lots of individual companies.
That is not an argument to get out of stocks
when the market inevitably drops.
Every bear market is different.
Bear markets happen due to uncertainty
and uncertainty is understandably hard to process.
Nobody can see where the bottom of a bear market is.
Historically, most bear markets
have been followed by recoveries,
rewarding those investors who stuck to their strategy.
It is true that some bear markets have not recovered,
but for a properly diversified investor,
hanging on through periods of uncertainty
has produced a reliably positive long term outcome.
Thanks for watching.
I'm Ben Felix of PWL Capital
and this is Common Sense Investing.
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(bright music)