Bear Markets, Corrections, and Benchmarks by Kendall J. Anderson, CFA, Anderson Griggs Investments
Since the last day of 1926 through today, the S&P 500 has had a total of eight bear markets. This is assuming a bear market is one with a decline of 20% or more. Since it has been eighty-five years since the first of these great bear markets, and five since the bottom of the last one, it might be interesting to see some details on each. Let’s take a trip down memory lane.
Source: James P. O’Shaughnessy, <em “mso-bidi-font-style:=”” normal”=””>What Works on Wall Street, Fourth Edition, pg. 65
Often when we look back at the past, we remember the good times, forgetting the bad times. As an investor and advisor I am totally surprised every time I look at these numbers. It’s not so much the decline or the duration to recovery, but the fact that I have been able to stick around through all the suffering and still, without a doubt, continue to have faith that owning shares of public companies will reward the owners despite these periodic bouts of massive declines in market values.
Of course results do speak louder than words. Let’s lean on the quantitative research of James P. O’Shaughnessy and take a look at the returns of the S&P 500 for the first three decades I’ve been in the business of professional investment management.
Summary Annual Return and Risk Results Data: S&P 500, January 1, 1979 to December 31, 2009
Source: James P. O’Shaughnessy, <em “mso-bidi-font-style:=”” normal”=””>What Works on Wall Street, Fourth Edition, pg. 78-79
These returns by themselves look pretty good; earning the average is not so bad. They look even better when you consider that these average returns began just a few short years after the crash of the 70’s and include three of the eight great bear markets of the last 85 years. Even more impressive is that these returns end just ten months after the market declined by 50.95%.
These two tables tell us a lot about long-term investing. From the first table, we can see that every bear market recovers. We can also see that a recovery in market value, on average, takes longer than the decline in value. It has been wise to buy into the declines if one has a little cash laying around. Also, if one is fully invested, it is better to stay invested rather than sell and wait for a recovery, when we cannot tell with any accuracy when the decline will stop and the recovery will begin. Nor do we know how long the recovery will take.
The second table reassures us that the market responds to growth in business value. Hanging on through thick and thin for the past three decades would have produced a return well in excess of inflation. The table also tells us that we would have been hard pressed to find a non-levered investment that produced a superior return for a person who only provided capital and no labor. Of course, there is always a price to pay, and the table gives us a hint of the cost of hanging on. The standard deviation of 15.44% sums this up. The general level of price changes from the average for any given year in the S&P 500 during this time was up or down 15.44%. This is the price paid for hanging on. You must be prepared at any time for the market value of your stock portfolio to experience a decline of 15% or more. Percentages don’t mean a lot to most of us, so let’s put that into dollars. You must be prepared at any time for every $100,000 you have invested in common stocks to decline by $15,440.
This discussion of volatility takes us to our next concern: market corrections. Corrections are temporary, less severe declines that usually have a shorter duration than bear markets. Corrections are so numerous that they should be considered normal. Carter Worth, in his recent article “Money in Motion” dated October 13, 2014, stated that there have been 209 corrections of 5% or greater since 1927. If you do the math, this is an average of 2.47 corrections per year for the past 85 years. I personally have given up keeping track of how many corrections I have lived through in my professional career. I just know there have been a lot of them.
Corrections happen, and they must be dealt with emotionally and financially. I wish I could tell you not to worry when the market falls, but I would be hypocritical if I did. I myself have the same stomach churning and loss of sleep, and I struggle to stop myself from doing something, anything, to fix the problems. However, I know that when I have reacted and tried to change things, I have done more damage than good. This doesn’t mean we can’t take advantage of the normal market declines to improve the quality of our portfolios. It also doesn’t mean we can’t minimize taxes by selectively offsetting taxable capital gains with capital losses, as long as we have alternatives to maintain market exposure. It doesn’t mean we can’t put any cash to work long-term, as long as the corrections provide bargain prices to make new investments. It does mean that we should, if we can, hold off on any major purchase that requires the sale of securities.
Most of you know I have taken a little pride in sharing my investment knowledge with Justin. He has absorbed every little thing I have shared over the past ten years, and we are now at the point where he is returning the favor by teaching this old dog a few new tricks. While I am proud of his growth as an investment professional, I am sorry to say that his best training has nothing to do with me. That training came from living through multiple corrections and the great crash of 2007. I do believe that having this experience early in his investment career positively affected his ability to manage portfolios for you and for our future clients. While I have taught Justin everything I have learned, the teacher in me just can’t stop. Libby is now in the learning phase, but she has an advantage, as she is receiving knowledge from both me and Justin. I am sure that she will add far more than she takes in providing better than average results for you.
We have been talking about the S&P 500 index, one of the best known and most used benchmarks for common stock returns over time. Benchmarks, when used correctly, can help us measure our own investment results over time against an average return. However, a warning is also necessary, as the misuse of benchmarks can cause far more damage to our financial well-being than good. This is driven by our desire to outperform the average and maximize our returns by chasing the best performing group of stocks or bonds for the past year or two.
Most individual investors will not have 100%