Lessons from the past

What started out to be a real world problem has rapidly spread into the financial markets with the fastest price declines recorded in history.  In years to come this financial crisis will become another statistic of markets.  In the next couple of days, weeks and months the emotions amplified by the health crisis requires a clear head and some context before making decisions.

The purpose of this article is to acknowledge the high levels of prevailing uncertainty as we sit in isolation and quarantine and provide investors and clients with factual insight of previous bear markets. A bear market is typically defined by a decline in the market of more than 20%.  The events leading to a bear market is of academic importance and not covered in this article.  It is worth reminding ourselves that in every previous crisis similar levels of angst, emotion, distress and fear relating to asset values were prevalent to what we are experiencing currently.

Analysis

S&P500 monthly data since 1950 (period post second world war) was used to analyse market behaviour during bear markets. A total of 6 bear markets (before the current sell-off) were identified which means that this event happens on average 1 in every 10 years.  Bear markets are therefore regular events and any investment strategy should allow for this by ensuring that short term cash flow needs (3 years and shorter) are covered with cash or near cash (liquid) investments which are not impacted by market corrections.

The bear markets identified and analysed occurred in 1962, 1969, 1973, 1987, 2000, 2007 and 2020.

Characteristics of bear markets

The table below summarises the different bear markets:

Start	End	Peak To Trough Decline (the crash)1	Duration of Drawdown (months)2	Time of Recovery (months)3	Recovery Performance (pa)4	Recovery/Drawdown Ratio5
1962-01-31	1962-06-30	-22.5%	6	14	24.4%	2.33
1969-01-31	1970-06-30	-29.0%	18	20	22.8%	1.11
1973-02-28	1974-12-31	-43.3%	23	66	10.9%	2.87
1987-09-30	1987-11-30	-30.2%	3	19	25.5%	6.33
2000-09-30	2002-09-30	-46.3%	25	55	14.5%	2.20
2007-11-30	2009-02-28	-52.6%	16	48	20.5%	3.00
2020-01-31	?	-30.4%	<3	?	?	?
Average ex 2020		-37.3%	15.2	37.0	19.8%	2.97

1. The non-annualised drop from the high point of the market to the lowest point.
2. The time it took to reach the low point.
3. The time to reach the previous high point from the low point.
4. The annualised performance recorded in the recovery phase.
5. A measure to express the recovery period relative to the drawdown period.

The following is worth highlighting:

• We do not know if the market has bottomed in the current crisis – the bottom can only be established after the fact. In other words, whilst headlines will announce the market crash and bad news, they can only announce the recovery after it has happened;
• The current sell-off is the fastest on record i.e. the rate of decline is the worst for the period under review.
• There were two other occasions where the sell-off’s were pretty fast: 1962 and 1987.
• In magnitude, this crisis is the fourth largest out of the total of seven and is almost identical in magnitude and duration to the 1987 crash.
• Bear markets which play out over a prolonged period of time typically have larger sell-off’s – this is probably due to structural fundamentals which, by definition, take longer to address/correct. Short sharp bear markets are typically caused by an unforeseen event or shock and the recovery period (in absolute number of months) tends to be shorter as well.
• Two out of the three longest corrections, was associated with an economic recession, the third became prolonged following 9/11 and the Iraqi wars.
• The average period of recovery is 37 months. The shortest recovery was 14 months (1962) and the longest recovery was 66 months (1973). This context is extremely important for investors currently given the rapid decline rooted in a shock event which would suggest that the recovery period could be below average.
• The recovery period is typically 3 times longer than the sell-off period. For very short and sharp bear markets this ratio can be longer, but remember that the drawdown period was pretty short to start with.  Intuitively it makes sense that the recovery ratio would be longer but note that the absolute number of months are relatively short.
• The average annualised performance in a recovery is 19.8% per annum.

The bear markets analysed are graphicly reflected below.  The bottom/low point of each bear market has been converged with each other so that the drawdown and recovery periods can be compared against each other.  We do not know if this crisis has bottomed yet, but for illustrative purposes it is included. Each bear market has been named by the year in which it started:

In addition to the points made in the previous section the following is highlighted from the above:

• 1973 and 2007 were both followed by recessions (labelled above in red). These recoveries therefor started in recessionary environments;
• Long recovery periods (associated with long sell-off periods) can still have significant sell-off periods in the recovery phase.

Where to from here?

Everyone is feeling the doom and gloom. The situation is real and we experience it every day. This article analysed previous periods of market distress with the aim of providing investors with context for decision making purposes to avoid making the financial impact real.  Below are some insights:

• The situation is extremely fluid and this is not the time to be restructuring investments. It is improbable that your risk profile or financial needs have changed during the last month.
• It is uncertain whether the market has bottomed. There are many speculators wanting to enter the market and bad news will continue to dominate headlines. Expect ongoing volatility although volatility has in all likelihood peaked.  A good discipline for those wanting to enter the market is to “average” in.
• A recession (probably priced in at current levels) could prolong the recovery, but bear in mind that the sell-off to date has been very short and was caused by an external shock and not by structural economic fundamentals.
• Local asset managers are reporting very attractive valuations domestically, some of these valuations have not been seen in many years.
• Risks remain. Companies with debt which cannot survive a pro-longed period of low revenue is at risk.
• It is probably too late to reduce your risk profile now. By changing it you will realise your current unrealised loss.
• As with any crisis the world will be a different place after this. Behaviour will change and new opportunities will arise.
• The old saying will and still holds for long term investors – “it is time in the market and not timing the market which counts”.

There is a saying amongst historians and statiticians that “history does not repeat itself but certainly rhymes”.  The interpretation would be that after each significant event the human race adapts/evolves to avoid the mistake in future. The current crisis has its roots in a medical emergency which is arguably a first for the modern world. The reaction of financial markets has been brutal, but it is not the first time and it will certainly not be the last.  Rhyming indeed and it would be a mistake not to learn from the past:

• This sell-off was not triggered by weak economic structural fundamentals, but an external shock. Historically such sell-offs had faster recoveries relative to sell-offs associated with weak economic fundamentals.  Whilst a recession is probable, it does not prohibit a recovery.
• Further weakness can be expected, any liquidation of investments at these levels have a high probability of permanent capital loss.