COVID-19 Stocks and the Three Bears: Historical Perspective on Bear Markets

COVID-19 STOCKS AND THE

THREE BEARS: HISTORICAL PERSPECTIVE ON BEAR MARKETS

JIM CAHN

Chief Investment Officer

As we are social distancing, a term that seems destined to be Merriam-Webster’s word of the year, it is easy to get swept up by gloomy economic headlines. It is a natural impulse, akin to rubbernecking on the highway. Just as rubbernecking grinds traffic to a halt, excessive worry causes us to miss the big picture.

The speed of price movements across all financial markets, equity, fixed income, currencies, commodities, etc. can be unsettling, and the sell-off is likely to produce anxiety, as it conjures up visions of 2008 and even the Great Depression. But while the circumstances surrounding the current bear market are certainly unique, the nature of the downturn is not.

Putting it into perspective

Since 1948, the S&P 500 has entered into 13 bear markets that lasted an average of 13 months with average cumulative declines of 25.8%. In other words, if this turns out to be an average bear market, and we’re currently 20% down, then we’ve already taken most of the pain. Despite that, you might hear pundits suggest that the average cumulative drop in bear markets is over 36%, but that includes the Great Depression—nothing suggests that we are headed in that direction.

More severe equity market declines are usually associated with failures within the financial system itself—think the bank runs in 1930 and the collapse of Wall Street giants in 2008. When financial institutions are strong, recessions and bear markets tend to be shallow. Luckily today, the financial system appears sound. Banks are well-capitalized, and liquidity—though stretched in some markets—continues to be generally plentiful.

Three kinds of bear markets

According to research by Goldman Sachs, there are three kinds of bear markets: cyclical, structural and eventdriven. It’s worth exploring each one as they tend to produce very different kinds of recessions.

CYCLICAL BEAR MARKET

Typically a function of rising rates, impending recession and falling profits

Average length: 27 months Average drawdown: -31%

STRUCTURAL BEAR MARKET

Triggered by structural imbalances and financial bubbles

Average length: 42 months Average drawdown: -57%

EVENT-DRIVEN BEAR MARKET

Triggered by a one-off shock that does not lead to a domestic recession

Average length: 9 months Average drawdown: -29%

Cyclical bear markets are associated with the normal fluctuation of the business cycle. If the economy gets too “hot,” the fed will raise rates to keep prices in line, resulting in a depressed outlook for economic growth and an associated sell-off. These types of bear markets have average declines of -31% and last, on average, 21 months.

Structural bear markets are caused by reversing a major bubble or imbalance in the economy. The 2008 financial crisis was such a bear market. Individuals and businesses were over-extended on debt as banks started lending to worse and worse candidates.

These types of bear markets tend to see deeper sell-offs as they are correcting a fundamental flaw in the markets. On average, structural bear markets see declines of 57% and a 42-month recovery. The reason for the increased depth and time to recover is that even after consumers start to feel comfortable enough to spend more and businesses want to invest, banks are too impaired to lend, resulting in stagnation as the banks heal.

The coronavirus caused an event-driven bear market

Event-driven bear markets are caused by the market attempting to price in the impact of a specific event. The declines after the 9/11 attacks are one example. Event-driven bear market sell-offs tend to be shallower, with an average decline of 29%, and the rebound tends to be much faster, averaging nine months.

Clearly, the current downturn is event-driven.

The primary event has not so much been the coronavirus itself, but the containment measures around COVID-19, which are slowing economic activity.

This is, of course, a disturbing health crisis, and indeed, the number of confirmed cases continues to rise both at home and abroad. However, fear of the disease itself seems to be impacting perceptions of the markets and their capacity for recovery.

A cause for optimism

However, data from China, Korea and Taiwan indicates that social distancing, along with testing, will slow the spread of the virus. The administration believes COVID-19 will be largely behind us by late summer. From there, the outlook is a bit rosier. Government stimulus packages, deferred demand and ultra-low interest rates are likely to fuel a fast recovery in economic activity.

Much has been said about the unprecedented decision by Saudi Arabia to increase oil production in the face of declining global demand brought about by the COVID-19 crisis. In previous years, this might have been a boon to economic growth, as lower fuel prices benefit the travel and manufacturing sectors.

However, the U.S. is now the world’s largest oil producer. Over the last two decades, the U.S. has invested substantially in building out its energy infrastructure, which means that many banks and investors hold debtbacked energy infrastructure businesses. While Saudi Arabia can produce oil for as low as $3 a barrel, domestic “frackers” need oil in the mid-$40s to make money on new wells.

But this, too, is an event. Price fixing, by definition, is outside of the typical market cycles, and it certainly doesn’t represent the correction of a flaw in the markets. Once the oil crisis subsides, as seems likely to happen this year, we have the infrastructure in place for a rebound.

Looking for opportunities

So, now that we have established a precedent for our current market conditions, we can look to identify opportunities. When markets sell off, there are often exceptional opportunities for future returns.

Further, diversification seems to be working to stem some losses, as high-quality bonds have generally rallied as equity markets have sold off. This provides an opportunity to rebalance portfolios, selling bonds that have become relatively expensive and buying stocks that come at a discount compared to only weeks ago.

Now is a good time to consider tax loss harvesting, using portfolio losses to offset gains in future years. Being able to use losses to save on taxes blunts the pain somewhat. With mortgage rates near all-time lows, it’s a great time to refinance. It is also a good time to consider a rollover from an employer plan to attain greater flexibility in your investments or a Roth conversion to reduce your tax burden.

All of these moves only make sense if you can look past the headlines and see the market for what it is—an attempt to valuate a worldwide pandemic until such a time we have a vaccine or effective treatment. That day is coming, and it’s best to plan accordingly amidst the doom and gloom.

Originally published on March 27, 2020