We’re in a Bear Market… Now What?

Today, the S&P 500 officially entered a bear market closing down more than 20% from the peak on January 3.  Year-to-date, 2022 has been difficult for investors, offering limited opportunities for positive returns.  In this update, we offer historical perspective on the bear market experience, highlight issues likely to shape the path forward (for better or worse), and evaluate the likelihood of a recession.  We understand that market drawdowns are unsettling, but remind our clients that maintaining discipline during periods of uncertainty is the most reliable course for growing and preserving wealth.

Not fun, but not uncommon.  Large drawdowns can be unsettling, but are much more common than most might appreciate.  Over roughly the last 100 years, we have experienced 33 drawdowns of 10% or more.  Eleven of those drawdowns were 20% or more otherwise known as “bear” markets.  This means investors should expect to experience a large drawdown about once every three years on average, including bear markets about once every ten years.  The good news is that equity markets have demonstrated a perfect record of recovering from drawdowns, eventually reaching new highs over time.

The chart above plots each of the historical drawdowns, highlighting that on average, much of the recovery tends to occur in the first year after a market bottom.  We can see that the pace and magnitude of the current drawdown (blue line) has been more severe than most, and actually looks a lot like the drawdown we experienced in the fourth quarter of 2018 (red line).

Uncertainties abound, markets pricing in bad news.  There are several key issues that may influence the path ahead.  Uncertainty in these areas is high and the range of potential outcomes wide.  Peace could break out in Eastern Europe, or the war could escalate rapidly.  The pandemic could be over or a resurgence in cases could elicit a variety of government responses around the world.  Inflationary pressures, exacerbated by the war in Ukraine and strict Covid policies in China, could moderate or persist.  Accelerated tightening by the Fed, arguably playing catch up in the battle against inflation, could be effective or push the economy into a recession.  It is impossible to know which way each of these issues, and others, will break, but it is safe to say that equity markets are pricing in quite a bit of bad news.

Sentiment, historically a contra indicator, is decidedly negative.  Investor sentiment is extremely negative right now.  The AAII Bearish sentiment index recently notched its fifth highest reading ever (dating back to 1988) with 59.4% of investors identifying as bears.  Historically, this metric has been pretty good contra indicator of what’s to come. The highest readings on record were in October 1990 (oil price shock, Iraq invades Kuwait) and March 2009 (financial crisis).  In both cases the most extreme levels of bearishness coincided with a market bottom.  In 1990, stocks returned 33% in the twelve months that followed and in 2009, stocks returned 66% in the twelve months that followed.  We also experienced elevated bearishness readings (very negative sentiment) in December 2018 (after a 20% market decline on recession fears) followed by a 28% return in 2019, and similar dynamics around March 2020.

Headed for recession or not so fast?  There are plenty of risks out there (there always are), but we also see some bright spots in the fundamentals.  The labor market is strong.  Unemployment is at the lowest level we’ve seen in 50 years.  There are almost two vacant jobs out there for every person counted as unemployed.  Household spending remains robust benefitting from savings built up during the pandemic and surveys of business people (purchasing managers index, PMIs) are still in expansionary territory.  The Fed is tightening policy in an effort to tamp down inflation – the market is expecting (and pricing) for this.  The risk would be tightening too quickly and driving the economy into a recession, but there appears to be enough underlying strength to provide some cushion for the blunt tools the Fed has to work with.  While a future recession is inevitable, our indicators suggest the risk of a recession in the next twelve months remains relatively low.

We will enter a recession at some point, and that’s ok.  Dating back to World War II, we’ve experienced a recession about every 4-5 years.  The question isn’t whether we will have another recession, the question is when.  Investors fear recessions because they often coincide with the larger drawdowns we described above.  That said, a disciplined and patient approach has historically paid off.  Looking all the way back to the great depression, the median recessionary experience includes a double-digit return in the 12 months leading up to the recession, a low single digit decline in the year of the recession and a double digit return in the year following the recession – netting an annualized return of almost 9% over the three year period.

We knew this would happen… sort of.  Our capital market assumptions rely heavily on the historical return experience.  Historical returns were not achieved in the absence of geopolitical events, natural disasters, health crises, presidential elections, legislation, regulation, deregulation, recessions etc.  The world is predictably unpredictable. If we look out over the next ten or twenty years, we can virtually guarantee we will encounter recessions, temporary market drawdowns, geopolitical issues and even the occasional pandemic.  We won’t always know what is coming, but if we know that certain types of events are pretty much guaranteed to happen, we can (and do) develop financial plans and construct client portfolios with that knowledge in mind.

Discipline is key.  In the short term, lots of things can and will come our way and there are always reasons to sell.  However over longer periods of time, we have a much better idea of what to expect and we know that discipline has historically been rewarded.  As unsettling as a bear market can be, we encourage our clients to stay focused on the longer-term and stay disciplined to the plan you have in place.  In the background, we are taking advantage of market opportunities where we see them, rebalancing to manage risk, and harvesting taxable losses where applicable.  Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals.  Please contact any member of our team if you have questions.