A Bear Market Checklist

A Bear Market Checklist

The S&P 500 is in the midst of its third bear market in the past four years.

If this one is different from the previous two, it’s because it lasted more than a blink of an eye.

At 9 months and counting from the all-time high reached in January, this is now the longest bear market we have seen since the 2007-09 crash. In comparison, the 2020 bear hit its low in just 1 month and the 2018 bear hit its low after just 3 months.

At the same time, stocks fell, bonds too.

Over the past 27 months, the US bond market has fallen more than 17%, the longest and deepest decline in history.

This came as a shock to many investors as the previous 8 times stocks were down in a calendar year, bonds ended up cushioning the blow.

That hasn’t been the case this year, and as a result, a 60/40 stock/bond portfolio is on course for its worst year since 2008.

Amidst all this carnage, there are two questions investors keep asking themselves:

  1. How long will bear markets in stocks and bonds last?
  2. How deep will the declines be before a bottom is reached?

Unfortunately, there is no answer to either question because every bear market is different. Since 1929, the average S&P 500 bear market has fallen 36% over 14 months, but the gap around that average has been extremely wide. And for bonds, we are already in uncharted territory, well beyond historic declines in duration and magnitude.

Which means trying to predict where and when a bottom will occur is a futile game to play.

What should an investor focus on instead? here is a checklist to consider

1) Know your time horizon

When the markets are steadily moving up, your time horizon can seem almost irrelevant. But when risk looms large, nothing could be more important.

Why?

Because if you invest with the cash you need over the next month or year, you’re more likely to become a forced seller, turning short-term volatility into a permanent loss. But if you’re investing for the next decade or more, time is on your side and all you need is the courage to stick with your portfolio through tough times.

What can help with this is perspective, knowing that every bear market in the past has eventually been followed by a new all-time high at some point in the future.

Since 1950, the average recovery time (from low to new high) for the S&P 500 (including dividends) has been 14 months, with the longest recovery taking 48 months. If that seems like an eternity, your time horizon may be too short and not compatible with investing in stocks.

In the bond market, we have never seen a full recovery take longer than 9 months from a low (with data going back to 1976). But just because something didn’t happen in the past doesn’t mean it can’t happen in the future. The depth of the current decline (-17%) suggests that the recovery is likely to take longer this time around. But if you’re a long-term bond investor, you can afford to be patient, and now at least you’re being paid a higher reward for waiting (see #4).

As an individual investor, time is your greatest asset. To use it effectively, know your time horizon.

2) Make sure you are truly diverse

Diversification is always important, but during long bull markets, this concept often falls on deaf ears. In the 40 years of a secular bond bull market that ended in 2020, owning the entire bond market would have served you pretty well (+7.6% annualized return from January 1981 to December 2020 in Bloomberg US Aggregate) . And over the last two years (+8.7% in 2019 and 7.5% in 2020) the gains made by diversification seem quite useless.

But the past is no prologue in investing, and with yields hitting historic lows in 2020, bonds as an asset class have become nearly all risk without reward.

The only way to reduce duration risk in aggregate indices was to look different, by allocating a higher percentage of your bond portfolio to less interest rate sensitive vehicles. This additional diversification has paid off so far this year, with short-term Treasuries (ex: $BIL ETF, +0.79%) and short-term corporate bonds (ex: $JPST ETF, +0.16%) both posting positive returns. However, duration is not the only diversification factor with the fixed income space. Credit can also provide benefits, as evidenced by floating rate leveraged loans (eg $BKLN ETF, -3.42%) which have significantly outperformed aggregate indices this year.

Note: As of 11/03/22

Within the equity market, diversification had also been rejected over the past decade, with portfolios concentrated in high-growth stocks (e.g. $ARKK ETF) and the Nasdaq 100 ($QQQ ETF) far outpacing any the rest. But there’s a cycle to everything, and the 14-year streak of above-value growth has started to revert to the mean.

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As a result, we have seen the stock outperform significantly this year (eg $IUSV ETF, -8.93%) while sectors with lower valuations such as energy (eg $XLE ETF, +68, 04%) outperformed everything else. Additionally, defensive areas like low volatility (ex: $SPLV ETF, -9.81%) fared significantly better than the Nasdaq 100 (ex: $QQQ ETF, -34.20%) and high growth stocks (e.g.: $ARKK ETF, -61.73%).

Note: As of 11/03/22

As 2022 dawned, a 60/40 portfolio of US stocks and bonds had enjoyed its best 3-year run since 1999, with a cumulative return of 58.8% (60% S&P 500, 40% Bloomberg US aggregate).

And just like back then, now was an opportune time to look for diversifiers with a low correlation to either asset class (see “Betting Against Buffett”). We’ve seen this in spades so far in 2022, with areas such as managed futures (ex: $AMFAX, +46.15%) and merger arbitrage (ex: $MERIX, +0 .23%) posting gains amid falling stocks and bonds.

3) Look for rebalancing opportunities

Market volatility tends to create greater dispersion in the performance of asset classes. This can lead to big shifts in your portfolio weightings and rebalancing opportunities. One of the most glaring opportunities today is in international equities, which have underperformed their US counterparts for nearly fifteen years.

The S&P 500’s ratio to the rest of the world is currently at its widest level in history, likely leaving an outsized position in US equities in many portfolios. No one knows what the future holds, but as we’ve seen with growth and value, a cycle can turn at any time. When this is the case, having some equity exposure outside of the US will prove beneficial.

Rebalancing is ultimately a risk management tool, taking profits from areas that have performed extremely well on a relative basis and adding to areas that have lagged. You do this not only to increase exposure to often unloved/cheaper lagging areas, but more importantly, as a hedge against abrupt mean reversions that can add unwanted volatility to your portfolio.

4) Focus on the bright side

During bear markets, there is always a long list of things to worry about, and this one is no exception. From recession fears to runaway inflation to the threat of nuclear war, all the news today seems like bad news.

It’s tempting during these times to switch entirely to cash, which easily beat stocks and bonds in 2022. But that’s focused on the short term and looking back. As your timeframe gets longer, the chances of cash being the best performing asset class decreases significantly.

And it’s becoming more and more true that cash seems to be “safer”. This is because after a long decline in stock and bond markets, valuations fall and yields rise, making stocks and bonds harder to beat.

In Treasuries, we haven’t seen such high returns since 2007.

With a 97% correlation between starting 10-year yields and future bond market returns, this is great news for long-term bond investors.

On the equity side, we entered the year with the highest US equity valuations since 2000, which have since fallen significantly.

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Although they are still far from “cheap” (the CAPE ratio of 28 remains in the highest decile), they are certainly cheaper than they used to be. And if the drops get worse from here, the potential future rewards will only keep getting better.

No one can tell you where and when bear markets in stocks and bonds will bottom. And that’s okay, because predicting the future is not a prerequisite for successful investing.

If you know your time horizon, make sure you’re really diverse, look for rebalancing opportunities, and focus on the bright side, you can handle just about anything that comes your way.


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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell securities. For our full disclosures, click here.

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