• Martin Fridson, CFA and Michael Livian, CFA

What to Expect during a Bear Market

The stock market officially entered bear market territory on Monday, June 13, according to the conventional definition of a 20% decline from the previous peak of the S&P 500 Index. Our clients’ accounts have benefited from previously instituted risk reduction steps in the equity portions of their portfolios. These have included cutting back on equities, increasing cash balances, and adding funds that are not highly correlated with stocks. What should investors expect now and what actions are likely to serve them best from this point?


History provides useful guidance on these questions. There have been 14 bear markets since World War II. Bespoke Investment Group, LLC has compiled statistics on those events that shed useful light.


How much longer may the decline continue?


After reaching the negative 20% threshold, the market continued falling for an additional 95 days on average, before hitting bottom. Averages can be deceiving, however. The lengths of the ongoing declines ranged from zero days in 1948 to 310 days in 1973. A better statistical measure in this case is the median, which is 43 days. (Half of the numbers are above this number and half are below.) Furthermore, in three of the last four bear markets, the bottom was reached in just 11 to 14 days.



How much further can the market fall before it hits a bottom?

The total peak-to-trough move in the 14 postwar bear markets had a median of

-30.22%. (In this case, the average was not wildly different, at -31.99%, indicating that the experience was more uniform.). In severe bear markets, the drop far exceeded these percentages.



Responding to the downturn


Based on these findings, we believe it is too early to “bottom fish,” that is, to seek bargains in depressed stocks on the assumption that they will shortly begin to rebound. We are humble enough to know that nobody can consistently time markets. Even the most quantitatively sophisticated of the would-be market-timers will probably start buying a bit too early or else miss some of the initial upside.


A special consideration in the present cycle is that the Fed is tightening credit in the face of a sharp decline in securities prices. In recent bear markets, by contrast, investors have been conditioned to rely on the “Fed put.” That is, the Fed tended to come to investors’ rescue by pumping money into the financial system, thereby contributing to the swift rebounds in three of the past four recessions. This occurred even though support of the securities market is not part of the Fed’s legislative mandate, which is limited to maintaining price stability consistent with full employment. With inflation currently running at a much higher rate than in recent decades, the Fed is determined to rein it in, regardless of the impact on stock prices.


The Fed is also resigned to the possibility that its anti-inflationary interest rate hikes will trigger a recession. That is important because Bespoke’s statistics show that it matters to the speed and vigor of a stock market rebound from a bear market whether crossing the -20% line is followed by a recession. In the six months following the certification of a bear market, the median S&P 500 price change has been +13.32% if the economy avoided a recession, but -3.07% if a recession ensued. If it becomes clear that economic expansion has given way to contraction, further risk-containment measures will require consideration.

As usual, maintaining a long-term perspective should serve investors well. Over the 12 months following the market’s reaching the -20% mark, it made little difference whether or not a recession ensued. The median S&P 500 price change of +23.90% in the no-recession scenario was not much lower than the +21.13% experienced in the recession scenario.


These median figures should not be interpreted as an indication that a strong rebound is guaranteed in the 12 months subsequent to the market entering bear market territory. In three postwar recessions, the S&P 500 registered a decline over that interval. Those cases were outnumbered by 11 rallies, however, a 78% significant success ratio. Therefore, if we are to be guided by history, it will eventually make sense to try to capitalize on stocks that have gotten much cheaper in the bear market.


Conclusions


For clients whose portfolios have undergone the abovementioned risk-reduction steps, no broad changes are warranted at this point. Naturally, we continue to study individual securities and replace any that do not satisfy our valuation criteria. For a small number of clients who have requested us to maintain higher equity allocations up until now, some trimming may be needed.


From this point, we will utilize the statistical data described above to determine appropriate times to use cash reserves to take advantage of depressed equity prices. If and when the S&P500 index drops more than -30.2% from its January peak, we will start adding to stocks.

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