Being more than a year into the current bear market, it’s natural to wonder when it will end. In this episode, Peter shares his thoughts on where we are in the market cycle and how to invest going forward.
Listen now and learn:
- Typical size and duration of bear market declines and recoveries
- The likelihood that the U.S. economy goes into recession
- Five insights on how to invest going forward
Listen Now
Show Notes
Thanks for tuning in this week for an episode that’s all about setting expectations for investors as we are in month 15 of a bear market. I never want this show to be about predicting the future, but I spend a lot of time thinking about the future and how it might (really, a lot of emphasis on might) impact our clients at Plancorp.
You see, all of our clients have financial plans that assume historical levels of market volatility will persist into the future. That means our financial plans expect downturns to occur with a similar frequency and magnitude as they have in the past.
How Often Do Bear Markets Occur and How Long Do They Last?
The standard definition of a bear market is a 20% decline from a market peak. For this episode, I’m going to use the S&P 500 as a proxy for the market for ease and simplicity.
See EP.87: How to Measure the Success of Your Portfolio
Since 1926, a bear market decline has occurred every 3.6 years – so they’re pretty normal. These types of declines are simply the cost of the higher expected returns from owning stocks.
Looking at all bear markets since World War II, the average time it takes for a bear market to reach its low is 12 months with an average decline of 30%.
The average amount of time it takes to return to the previous high-water mark is 20 months.
As of this recording, the current bear market decline reached its lowest point on October 14, 2022, with a price loss of 25.3%.
Obviously, no two bear markets are exactly the same. Each has unique characteristics that differentiate them in history books, but also give them the uncanny ability to make timeless investing principles seem outdated; because in the moment, those unique characteristics make the world feel “different this time.”
Having coached clients through (what I’ll call) four bear markets in my career, I definitely agree that some bear markets feel worse than others. And in my experience, how a person perceives the relative riskiness of a given bear market also has a lot to do with your personal experiences and worldview.
But regardless of your age or life stage, the key to successful investing through a bear market is the same for everyone: stick to your plan.
When things seem uncertain or scary, our deeply ingrained human instinct is to do something.
And let me be 100% clear: there is nothing wrong with feeling that way. Both your and my behaviors have been shaped by hundreds of thousands of years of our species’ evolution.
Investment success largely comes down to minimizing mistakes and the choices you make in a market downturn are most likely to be the primary determinant of your investing success.
So it’s okay to feel that urge to do something, but that something should rarely be in your portfolio.
When Should We Expect the Bear Market to End?
Happiness is the difference between expectations and reality.
When I speak with a client about markets for the first time — regardless of how long they’ve been working with Plancorp or where we are in the market cycle — I always talk about the normalcy of losses.
How normal are losses?
Well, the S&P 500 experiences a 10% decline or more roughly once every 12 months. As I said earlier, it experiences a 20% decline or more about every 3.6 years. And it experiences a 30% or more decline roughly once a decade.
Now, these are just averages. Market declines don’t happen on a regular schedule that can be mapped out on a calendar. But anyone with exposure to stocks should basically expect the market to decline by at least 10% every year for any number of reasons.
Market volatility is incredibly normal. It is the cost of the higher expected returns stocks provide and that are necessary to help your savings grow faster than inflation.
Let’s be honest, it would be great if we could meet all our life’s goals by socking away our savings in cash and never risk having it lose its nominal value. But, in reality, doing so would require an astronomically high savings rate and far more years in the labor force than what most people would deem to be realistic.
So we invest, usually in a mix of stocks and bonds. Stocks are the primary driver of returns, and those returns come with risk. Risk can be defined in a number of ways. But regardless of how you define it, risk and return are closely related.
That’s why I spend so much time with clients talking about losses, whether we are in a bull market or a bear market. And so, even though it’s not guaranteed to occur, I usually tell people that it’s best to assume markets will experience a 10% decline every year.
Bear markets of at least 20%, while they occur far less frequently, still occur regularly. When they do happen, it’s common for market pundits to compare current downturns to past ones and try to make an inference about how the current situation will play out.
Looking to history as a guide for what might happen in the future isn’t necessarily the worst thing — in fact, I’m sort of about to do it myself — but I think comparing the current bear market to specific bear markets of the past creates a false sense of cause and effect.
This is a bit of a nuanced point, so rather than taking a giant detour, I’d encourage you to go back to Episode 14: How Markets Work as well as Episode 70: Thinking of Markets Like Piles of Sand explain how markets are complex adaptive systems in which cause and effect aren’t neatly linked.
That’s a lot of setup to basically say that I don’t love comparing the current bear market to past individual bear markets….all so that I can say I do think you can look at bear markets in the aggregate to set reasonable expectations for the next 12 to 18 months.
In my opinion, having a better sense of the range of outcomes will make the bad ones less scary and the good ones less exciting — both of which help dampen our extremely normal and natural human tendency to react and want to deviate from our investment plan.
So at the top of the episode, I said that the average bear market decline lasts 12 months and reaches an average maximum drawdown of 30%. The average time it takes to recover from the losses is 20 months.
But if we were to look just at bear markets that coincide with a recession, those bear markets take an average of 18 months to bottom out and the max decline is an average of 37%. The average recovery time from a bear market paired with a recession is 30 months.
Meanwhile, bear markets without a recession are shorter, taking an average of 7 months to bottom out and experiencing an average max decline of 24%. In these bear markets, the average length of recovery is 10 months.
So the million-dollar question is: will there be a recession or not?
Will the U.S. Have a Recession or Soft Landing?
I have no idea whether we will have a recession or not. Markets seemed to be pricing in a recession in 2022 when the S&P 500 was down 25% and the Federal Reserve was hiking interest rates at the most aggressive pace since the 1980s.
The Fed is a key figure in this discussion. They started tightening monetary policy in response to high inflation. In most instances, but not all, when the Fed tightens monetary policy, it often spells the end of economic expansion and the beginning of a recession.
Throughout the tightening cycle, the Fed has been publicly hoping for what is called a “soft landing.” The term originates from the method of landing a hot air balloon by gradually reducing its buoyancy. So when you hear about a “soft landing,” the idea is that the Federal Reserve tightens monetary policy to fight inflation without causing a recession.
When inflation peaked in 2022, markets seemed to be priced in that the Fed would reduce interest rates by the end of 2023, but in a world where happiness is the difference between expectations and reality, I personally don’t believe that’s a good expectation.
Since 1971 (a relevant starting point because by that time the US Dollar was no longer tied to the price of gold), economists typically agree that a soft landing has been achieved twice (in 1984 and 1995). But in the six other instances, tightening cycles were followed by a recession.
What makes projecting current conditions out into the future difficult is that both soft-landing and recession scenarios start out the same. Both begin with interest rates rising, followed by markets pricing in future cuts and stocks rallying. If a soft-landing plays out, the story ends here. But in recessionary scenarios, you start to see unemployment rise, housing weaken, and stock prices decline.
Now, I really hate to be a downer, but I’m all about setting expectations right now….so I must point out that in previous rate-hiking cycles, soft landings were preceded by relatively low inflation and looser bank lending standards – both of which are the exact opposite of today’s circumstances.
There is also what many consider to be the truest recession indicator flashing recession. Typically long-term bond yields are higher than short-term bond yields. But since World War II, that relationship has inverted eight times such that short-term bonds have higher yields than long-term bonds, and in all instances, a recession followed.
The gap between the ten-year and three-month Treasury yields turned negative again in October 2022. When that happened, the predictions for a recession increased.
And yet the person who created this measure as a predictor of recession currently feels that this indicator may not be as effective this time around.
Professor Campbell Harvey first linked the shape of the yield curve to the future path of U.S. economic growth, but he has given a few reasons why the current inversion doesn’t necessarily mean a recession is imminent.
For starters, for an indicator that is so well known and covered in popular media, it’s likely that the awareness induces consumers and corporations to increase savings and avoid major investment projects. Another positive is that the red-hot job market is red hot, which should help laid-off workers find new jobs more quickly than usual.
In my opinion, the most important argument Harvey makes is that his original yield curve model was linked to inflation-adjusted yields. There aren’t inflation-adjusted three-month Treasury rates, but the 10-year real rate is above 1% and the one-year real return (using the latest CPI reading) is negative – thus the real (or inflation-adjusted) yield curve remains positively sloped.
What Does It All Mean?
So where does that leave things?
Nobody knows where the economy and market are going. Nobody. Lots of really smart people can give you opinions backed by facts, but they’re still opinions at the end of the day and not holistic evidence.
If we do have a recession, then it’s reasonable to expect the market to take another leg down and take longer to return to the previous market peak. That’s just me looking at the history of bear markets with and without a recession.
But I want to make something very clear: the economy is not the stock market. A recession usually isn’t declared until well after it has begun. Sometimes it is declared after the recession is already over.
So I don’t want you to get too hung up on economic headlines in the coming months. For all we know, we’re in a recession right now because there are certainly pockets of data that would support that idea.
Waiting for a recession to take hold is costly, just take a look at this table from JP Morgan Asset Management that shows the cost of waiting for economic recovery before investing.
Here’s also a chart from Avantis Investors that looks at returns during recessions and expansions. What stands out to me is how markets react quickly to possible bad news in the first half of recessions.
As share prices fall, the expected return for investing increases. But in the second half of a recession, the market begins to incorporate improving expectations as the bad news gets less bad. I think that’s something a lot of people misunderstand: that market returns turn positive well before “good news” starts to roll in.
It’s possible that we’re currently experiencing the disappointing returns often seen during the first half of recessions. The market seems to have already priced in a lot of bad news and the potential for turmoil. But we can’t know for sure, which brings me to my next point…
If your portfolio was built on the basis of a financial plan that takes bear markets and recessions into consideration, there is no reason to deviate from your investment plan.
At Plancorp, we assume market downturns will occur with a similar frequency and magnitude as they have in the past. So rather than need to predict these things, we simply plan for them.
A globally diversified portfolio provides exposure to markets with different levels of expected returns. In fact, current valuations of U.S. versus non-U.S. equity markets would suggest that global exposure may boost returns over the next decade.
Investing is a long-term endeavor. By talking about the range of potential outcomes for the next 12-24 months, I’m hoping to reduce any anxiety that may occur as events unfold.
But unless you need to spend the entire value of your portfolio in the next year or two, what happens next doesn’t really matter. To expect markets will be lower three years or five years from now is a very low probability bet. Expecting them to be lower five or ten years is an even worse bet.
Twenty years from now? This is a time period that I truly associate with long-term investing, and the headlines of today will look like mere blips on a chart of long-term market prices.
Being an optimist doesn’t mean ignoring the fact that things are bad and could get potentially worse. But betting against the human spirit has historically been a bad bet. And if you think things will never get better, the evidence is stacked against you.
I’ve long believed that the key to investment success is minimizing mistakes. Believing the future will not get better for ourselves or the financial markets is a devastating mistake.
It’s periods like these where the market requires you to embrace fear and uncertainty in exchange for the returns you need to compound your wealth over time.
Again, unless you need your entire portfolio to meet living expenses in the next year, the benefit of missing some of the downsides is far less impactful than ensuring you capture the upside whenever it comes.
Your long-term returns will be greatly impacted by the decisions you make in a bear market. Choose to be an optimist.
As always, thanks for reading and listening. And until next time, to long-term investing!
Resources:
- Episode 14: How Markets Work
- Episode 70: Thinking of Markets Like Piles of Sand
- Episode 87: How to Measure the Success of Your Portfolio
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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