Learning to Live with Bear Markets
Historical Perspective on the Bear Markets of 2022
As most of you know by now, the S&P 500 officially entered bear market territory in June when it closed more than 20% below the stock index’s all-time high set in the first couple of trading days of this year. International stocks, as represented by the MSCI EAFA Index, are also in a bear market by this definition. It's worth keeping in mind that bear markets in stocks are reasonably common in this country, taking place on average about every 3 1/2 years.
We don't often talk about bear markets in bonds. But considering that bonds are a less volatile asset class than stocks, it's reasonable to define a bond bear market as a 10% drop in the value of the Aggregate Bond Index. By that definition, we're now also in a bond bear market. And historically, bond bear markets have been far more rare than stock bear markets. As an indication of this, I was a Wall St. bond trader during the previous one in 1994, which is also the last time before this year that the Federal Reserve raised its interest rates by 3/4 of a percentage point in one move.
It's not a coincidence that we're experiencing a bond bear market and a stock bear market simultaneously. While there is often only a tenuous link between cause and effect in the financial markets, it's quite clear that stocks are feeling the effects of higher interest rates, that this year's bond bear market is largely responsible for the stock bear market. Rising interest rates transmit to lower stock prices in a number of ways, and you can read about these mechanisms in this recent CNBC.com article on why higher bond yields are bad news for the stock market and its investors.
The simultaneous occurrence of a stock bear market and a bond bear market is extremely rare in the history of our financial markets. It's also particularly disheartening to investors because well-intentioned, but standard, attempts at portfolio diversification aren't providing much downside protection. Investors can usually take comfort from high-quality bonds appreciating in value when stocks are suffering as a result of recessions or financial stress. This was certainly the case during the recent COVID-related recession and during the bursting of the real estate bubble in 2008.
By contrast, bond prices have fallen along with stocks this year as most of the major central banks around the world scramble to withdraw COVID-related liquidity in a belated attempt to reduce inflation. Consider then the "plain vanilla" diversified portfolio allocated 60% to U.S. stocks and 40% to high-quality bonds. The performance of this portfolio allocation in the year to date is amongst the worst ever.
Thankfully, we as investors are not constrained to this "plain vanilla" 60/40 portfolio allocation. For one thing, bonds and bond mutual funds come in many different flavors, offering a spectrum of exposures to credit risk, interest rate risk, currency risk, and so on. Similarly, stock mutual funds vary widely in terms of their exposures not just to stock markets outside of the U.S., but as importantly, to the "strategic beta" factors that I've discussed previously in an Articles on Wealth Management Topics blog post.
Portfolio Management Going Forward
As most of you know by now, I don't presume to have any more ability to predict the future of financial markets than any other observer or practitioner. However, in case you find it informative or instructive, the following is an excerpt from a Client Letter I wrote on June 22, just after U.S. stocks first entered into a bear market:
"... I don't think we've seen the end of this bear market in U.S. stocks. For one thing, during the last century or so, the average bear market has lasted about 10 1/2 months with an average drop from top to bottom of about 36%. This bear market is less than 6 months old, with a drop through last Friday of about 22%.
And the severity of bear markets tends to be directly related to the amount of speculative excess experienced during the prior bull market. How much speculative excess we experienced during the bull market that ended in January is, however, open to debate. By some metrics, the stock market was as expensive, or even more so, as the dot-com bubble market that popped in 2000. And that ensuing bear market lasted 2 1/2 years, the longest ever.
More anecdotally (and I realize there are dissenters among you), I would argue that in the recent bull market: (a) the emergence of investments like special purpose acquisition companies (SPAC's), cryptocurrencies, and meme stocks, and (b) the widespread belief held by investors and financial advisors alike that a small subset of stocks (the FAANG stocks and a few select others) were impervious to market forces, were both indications of speculative excess.
Not to mention that the Federal Reserve is just a few weeks into its so-called "quantitative tightening" initiative, the reduction of the size of its balance sheet. This process is unknown territory for investors, and the performance of U.S. stocks - and of tech stocks in particular - has been closely related to changes in the size of the Fed's balance sheet in recent years.
In addition, bear markets have a way of dispelling the most tightly held but misguided beliefs created in the prior bull market. Chief among these in the most recent bull market were that all dips must be bought and will be immediately rewarded, and that the Federal Reserve will ride to the rescue in the case of any adversity in the financial markets. And who can blame investors for believing this? This is what they've experienced for the last 13 or so years. Many have never experienced anything else. I suspect this bear market will offer many false dawns, and I suspect that central banks on the whole will be unexpectedly unforgiving in their fight against inflation.
But then, this is only one man's opinion. As a reflection of it, though, I'm not in much of a hurry to rectify the current over-allocations to commodities and under-allocations to equities that currently exist in most clients' portfolios."
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.