We have pleasure in sharing with you, farrelly’s SPOTLIGHT.
A service that provides in depth coverage of subjects that are of interest to long-term investors but perhaps not well covered by mainstream research providers.
For many years Greg has been a champion of Tim Farrelly’s Investment Strategy which brings a long-term focus to the outlook for markets – a focus which delivers far more reliable and useful observations than the majority of analysis that has an essentially short-term perspective.
Over the course of the year there will be eight SPOTLIGHT reports that will review subjects such as the outlook for residential property, interest rates, hedge funds, private equity, private debt, gold, and where active managers do and don’t make sense. It will attempt to debunk some of the many myths that enjoy such currency in the investment world.
SPOTLIGHT aims to be evidence based, long-term in orientation, written in plain English and, above all, useful for investment decision makers.
We hope you find the content of interest.
From the team at Davis Private Wealth.
Executive Summary
While equities do outperform in the long-term, the price we pay are the bear-markets which periodically come along to test our staying power; panic selling during a bear- market turns long-term outperformance into underperformance. This SPOTLIGHT is a guide to help investors survive bear-markets. It looks at the historical evidence back to 1967 to address some key questions. Are we at the beginning or close to the end of this bear-market? What if the global economy moves into recession? What are the best strategies to avoid being hurt during a major equity market downturn? And more.
On average equities fall by 42% during bear-markets – but may fall by much more
This study looks at the 25 bear-markets that have occurred in the Australian, US, Japanese and UK sharemarkets during the past 55 years to find that, on average, we see a bear market once every 9 years in each market. On average, the falls have been -42%, they last 18 months but can take years to permanently recover.
Looking beyond the averages, we separately examine all of these bear-markets and see considerable variation from the averages. The worst downturns are much larger than average; worst ever falls were –81% in Japan, -71% in the UK, -55% in Australia and –53% in the US. The time taken to fall and recover also varied dramatically from case to case.
There are three main drivers of bear-markets
Major bear-markets typically begin with a shock to the system such as the Covid crisis, they then fall further to remove the excessive valuations that are so often associated with bear-markets. They normally end with a panic phase where fear and indiscriminate selling sends prices sharply lower. This last phase is a time to be buying not selling.
Using timing to avoid bear-markets is problematic
Shocks are, by their nature, unpredictable. Even recessions, which are often associated with major bear-markets are not reliable guides as to when to sell and buy back. Similarly, excessive valuations, which are mostly present at the start of bear-markets, tell us little about when a downturn may begin. Timing is very difficult.
The damage caused by bear-markets can be managed
There are a number of strategies investors should consider. Avoid overpriced assets. Understand how severe and how often bear-markets occur. Set the amount you invest in risky assets at a level where you will be able to tolerate the inevitable downturns without becoming a panic seller. Diversify; boring but it does generally help reduce downturns. Re-balance and buy back into cheap assets during the panic phase when the best opportunities abound. Don’t wait until everything looks rosy, by then, markets will have already moved much higher.
Equity markets have been falling over the course of 2022. Market pundits are divided as to whether this will turn into a major bear-market or whether it is a buying opportunity. In this SPOTLIGHT we examine how far markets fall during bear-markets, what are the causes of those bear-markets, the typical stages of bear-markets and what damage we can expect to avoid and what we cannot. We begin in Figure 1 with the data on average bear-markets from Australian, US, Japanese and UK equities since 1967.
A quick scan of this table tells us a lot;
- We should expect to see a major bear-market roughly once every 9 years. Long enough for investors to forget the lessons of the previous fall;
- The average fall is large – around a 40% loss of capital. To put that in context, a 40% fall requires a 66% gain in order to get us back to the starting point
- Falls can be much larger than the average and that extra fall can be very damaging. The worst fall for Australia was –55%. An investor who bought in after the fall reached the average level of –41% would experience another 25% fall before the market bottomed; an investor in the UK who bought in at the average fall of -42% in 1975 would have experienced a further 50% loss of capital before the market bottomed at a –71% fall.
- Markets fall quickly but recover slowly. While the average fall takes around 18 months, the average recovery takes 8 years; 5 years if we exclude the Japanese experience which has been much worse than other markets over the past 60 years
Some definitions
In this article a bear-market is defined as declines in the index of more than 25% when measured on a month end basis. We have chosen that definition rather than the more conventional loss of 20% because falls that don’t get to the 25% mark are typically shorter in duration and recover much more quickly. We have used month end prices rather than daily prices because that is more reflective of the way that investors receive information via their statements and manager reports.
In Figure 1 we show averages with and without Japan. The reason for that is that Japan experienced a bubble in the late 1980’s of a magnitude much greater than anything seen in other major equity markets over the past 90 years. We think it is unlikely to be repeated any time soon and, so, the average ex-Japan is probably more representative.
Nonetheless, in Figure 5 on page 7 we show each of these 25 bear-markets that are summarised in Figure 1. In many cases, reviewing the fine detail can give a much richer insight than merely looking at averages. In particular, we separately report the Japanese data just to be very clear what damage an out and out bubble can do.
What causes bear-markets?
Bear-markets can be driven by a number of factors of which the major ones are shocks, excessive valuations and sheer panic. Often we get all three acting in concert. Recessions and rising interest rates have a part to play as well – and often are major contributors to, or the result of, a shock to the system.
Figure 2 below outlines farrelly’s assessment of all major bear-markets since 1967.
The normal pattern is that we have a shock to the system which causes markets to fall as investors react (and generally over-react) to the shock. This is often followed by a re- assessment of valuations causing further falls, particularly if markets are overpriced. Finally, we normally see a period of outright panic where equities become very cheap – and great buying for those with the courage to act when all around are losing their heads. (With apologies to Rudyard Kipling)
The role of shocks
Shocks can take many forms; credit crises, large interest rate hikes, huge oil prices rises, wars or pandemics – most, one way or another, lead to recessions. Recessions lead to falls in company profits and higher corporate failure rates. All of which make investors nervous. Often very nervous.
Normally, the long-term impact of these shocks is not large and shouldn’t reduce the value of equity markets by more than 5% to 10%. A clear example was the Covid crisis in early 2020; at the time our analysis was that Covid could reduce the long term value of stocks by about 3% to 5% and yet, prices fell much more in the short-term. But, as we know, prices recovered very, very quickly as markets came to the same view.
While the true long-term impacts of shocks are not large, they normally are the critical catalyst required to trigger a bear-market. After the shock, investors begin to review valuations, particularly very optimistic valuations and mark prices back to more realistic levels. Until the shock arrives, investors are happy to believe in best-case scenarios or, at extremes, outright fantasies.
The role of recessions
Figure 3 below shows US recessions in the pale blue with the size of the downturn in the S&P 500 shown in orange. Note the scale is negative, the bottom of the 2009 downturn shows a loss in excess of -50%. What we see here is that bear-markets are usually, but not always, associated with recessions but that the impacts are very uneven.
Sometimes markets anticipate recessions while, at other times, prices don’t start to fall until after a recession has begun. Sometimes the markets bottom out before the end of a recession, sometimes during the recession and sometimes well after the recession has ended. We also see that the depth of the fall associated with recessions is very uneven. Figure 3 shows falls of 15%, 20%, 55% and many levels in between. There is no typical fall associated with a recession. And so, using economic data to time entry and exit points is a very unreliable strategy.
The role of interest rates
Interest rates do have an impact on equity markets but, again, the effects are very uneven. Figure 4 below shows the interaction between rising interest rate environments in the US and equity bear-markets with the pale blue areas representing periods of rising cash rates. Again we see uneven responses to changing interest rates – rising rates sometimes cause markets to fall at other times markets begin to fall well after the rate rises are over.
While rising interest rates (and the possibility of a US recession) are definitely contributing to the current equity market downturn, using interest rates to help guide equity strategy is, at best, a dark art.
The role of valuations
In the long term, markets tend to gravitate to fair value but in the medium term go to excesses of pessimism or optimism when prices become very cheap or overpriced. Sometimes the optimism becomes so extreme that markets can be considered in bubble territory. Japanese equities in the late 1980’s and US equities during the late 1990’s tech boom are prime examples of bubbles.
In Figure 5 on the following page we show all bear-markets in Australia, the United States, Japan and the UK since 1967 and, in particular, show the valuation status of each market at its peak.
By way of explanation, our definitions of valuation are based upon the difference in expected long-term returns of equities compared to fixed interest – often referred to as the Equity Risk Premium. Historically, equities have returned about 4 to 5% per annum higher than cash – and so, that becomes our benchmark. When equities are expected to return 5% higher than cash and fixed interest we consider them cheap; when they are expected to return less than cash and fixed interest we consider them to be overpriced.
If they are expected to produce returns that are only a little better than cash and fixed interest we consider them fully priced. At other times they are considered fair value.
From the table below we can clearly see that in major bear-markets, valuations can play a critical role in both the size and duration of the fall.
Of the 26 bear-markets in our sample 17 began when a market was overpriced, six occurred when markets were fully priced and two started when markets were fairly valued. No major bear-markets began when markets were cheap.
As a rough guide, a market that is fully priced needs to fall about 20% to restore fair value while an overpriced market needs to fall around 33% to restore fair value. Why then are bear-markets often so much more severe than those estimates would indicate?
Panic sets in
The answer is that in the final stage of most bear-markets panic sets in and investors dump stocks regardless of valuation. The panic stage of the market is where we often see near vertical drops in prices. If a 35% fall gets us to Fair Value we often see prices fall a further 25% to 35% after that.
At this time we often see markets fall well past fair value into cheap territory and sometimes become extraordinarily cheap.
The panic phase is where investors fear the worst and have an almost uncontrollable urge to sell. In reality, this is the time to be buying not selling as hard as that may seem at the time.
Minimizing the pain that bear-markets cause
Bear-markets are painful. And dangerous. However, there are several steps that investors should take to ensure the damage is minimized.
Don’t panic!
This is the most important step. And, in some ways, the hardest to execute. It’s all well to say “don’t panic” but that is easier said than done when your life savings seem to be disappearing before your eyes. The result of panic is almost always disaster. During the panic phase of bear-markets prices have generally fallen by between 25% and 50% – by selling at that time means we are locking in these losses forever – panic sellers rarely buy back at a lower price.
The two keys to avoiding panic selling are to understand historical bear-markets and to make sure that you can handle the sort of damage that bear-markets can deliver.
Understanding bear-markets is the whole point of this report. Figure 5 contains a detailed picture of historical bear-markets, how far they fall, how long that fall takes and how long the recovery may take. Spend some time reviewing it.
Ensuring that you can tolerate these bear-markets is one of the most important steps in the financial planning process – generally described as risk profiling. While over simplifying the process, risk profiling essentially boils down to understanding that a portfolio with 100% in growth assets is likely to fall by somewhere between 30% and 50% at least once every ten years. A portfolio with 50% in growth assets is likely to fall by 15% to 25% at least once every ten years. Can you handle a 50% fall? A 25% fall?
Further, we should not underestimate the impact of the reporting of the bear-market while it is occurring. During the Global Financial Crisis, many serious financial commentators were talking about the collapse of the global financial system and a return to the Great Depression. During the Australian bear-market in 1990, there were well placed fears that one or more Australian banks could be declared insolvent and that such a failure could cause a long-term collapse in the Australian economy. During the Covid downturn in March 2020, a total breakdown in society was contemplated.
Bear-markets do not occur in a vacuum, the shocks that we have described in the opening section are very real and it is not difficult to imagine the worst when we are in the middle of the crisis. What we do know from history is that the actual outcomes of shocks rarely come close to our worst fears.
Be diversified
During equity bear-markets, we mostly see all markets fall which leads many to conclude that diversification doesn’t work. Nothing could be further from the truth. Figure 6 below shows how other equity markets fared during those US bear-markets. It also shows the average of the four markets during those downturns. We see that being diversified significantly reduces the size of the downturn in three of the six downturns and doesn’t hurt in the other three. The seventh, recent downturn is also shown even though we are in the middle of it. So far, diversification has been a help, again.
While diversification doesn’t always help, often it does make a significant difference and it rarely hurts. This analysis is from the perspective of a US investor. We get similar results when looking at other markets and, in particular, if we ran this analysis from the perspective of a Japanese investor, the results would be dramatically more positive.
Avoid Overpriced markets
The correlation between severe bear-markets and overpriced markets is quite clear. Many believe that market over-valuation cannot be identified in advance. We strongly disagree but recognize that valuation analysis has its challenges – not least of which is the fact that the time lag between a market becoming overvalued and entering a bear market is very, very variable.
Using valuation as a basis for timing the beginning and end of bear-markets simply does not work. On the other hand, avoiding markets that are overpriced in favour of those that are more reasonably priced has a long history of providing better returns and reducing the impact of downturns.
Rebalance before the crisis has passed
During the final panic phase, bear-markets often overshoot on the downside as investors dump shares regardless of value. During the panic phase, investors are normally well below their target exposure to growth assets, either because the value of their growth assets has fallen much more than their defensive assets or because they had reduced their exposure to growth assets in advance of the fall. In either event, there comes a time to buy back into these assets, ideally at very attractive prices. The challenge is when to make this move? Do we wait for the economic environment to become clearer? For interest rates to start falling? For valuations to become attractive?
From farrelly’s experience we would say no to all three – and particularly the first. Inevitably, by the time that the crisis that triggered the downturn has passed, or that the economic outlook is becoming brighter, prices will have risen substantially above the lows. The opportunity to re-invest at bargain prices will have passed.
We recommend that the best approach is to ignore trying to time the re-entry and instead move back in several small steps when valuations appear attractive. By using this approach we at least get partially reset in the event that prices rebound quickly. On the other hand, if the panic phase is drawn out, we continue to get set at lower and lower prices. An example of an extended panic phase was the second half of the Global Financial Crisis when new shocks – such as the failure of Lehman Brothers – occurred late in the bear-market.
Taking an incremental approach to re-investment is good for investors’ mental health, as well. This is critical at a time that is highly stressful for all investors. If we only get partially set before the market bottoms, we have the comfort of knowing we have at least secured some bargains and that the rest of the portfolio is recovering. If markets continue to fall, we know we have only partly committed and can now take advantage of better and better bargains.
