How bear markets end and the path forward for investors

No sane investor sets out intending to lose money - but when this outcome nonetheless transpires the experience can be psychologically racking for investors, novice and professional alike. Between the uncertainty, the relentless flashing of red that accentuates our loss aversion, one unifying theme often lost amidst downturns is that every U.S. bear market has ended. By examining over 40 years of bear markets, we can better turn towards understanding and knowledge rather than raw fear when selloffs strike.

Despite their mythologized status as financial albatrosses, bear markets are relatively frequent and indeed normal occurrences investors should expect over the long run. For instance, U.S. equities have endured nine bear markets since 1980, meaning they have occurred on average every 4.5 years. Using the SEC’s definition of a 20% decline covering at least a two-month period, investors have been in bear markets 15.6% during this time horizon. Moreover, bear markets occur 50% more frequently than recessions. While perhaps unnerving, this mental reframe helps investors see bear markets not as cataclysms, but routine phases in the long-term returns of capital markets.

Source: Russell 3000 as of July, 31 2022. Past performance is no guarantee to future results. Please see the end for important disclosures.

Using the Russell 3000 to calculate performance, the average drawdown and duration is 30.9% and 9 months, respectively. These averages, however, are not reflective of any individual bear market on record as the data follow barbell distribution along dimensions of both depth and duration. In other words, market declines tend to be either short (approximately 3 months), or much longer (approximately 20 months), with no middle ground; there is no middle ground. This same phenomenon presents itself sell-off intensity, where market declines cluster either at almost precisely 20% losses or at much more severe levels of a one third loss or more.

Graphically, this empty centre is distinctive and lends us four archetypical models for bear markets, namely short and shallow, short and deep, long and shallow and long and deep (we will profile these as black, Grizzly, brown and polar bears, respectively). While it this latter profile that everyone fears, it is important to note they constitute only slightly more than one fifth of bear markets over this period, and they reflect systemic market failure or massive economic disequilibria. The Dot com crash and the Great Financial Crisis, witnessing 47.4% and 55.7% drawdowns respectively, are quite differentiated not only by quantitative characteristics, but the nature of their causes; polar bears truly are in a league of their own and can give asset prices a real mauling.

By means of contrast, the short and shallow bear markets are the most numerous type representing one third of all declines. These black bear markets are strikingly consistent in behaviour, uniformly at 3 months in length and just surpassing a 20% decline. Composed of the 1990, 1998 Russian default/EM crisis and the 2018 December crash (where Powell notoriously exclaimed the Fed was contracting on “autopilot” in his first press conference) black bear markets are more akin to an aggressive correction than their polar bear brethren.

On the short and deep front, the archetype Grizzly bear includes the Covid crash and the 1987 portfolio insurance crash (yes, algos have long distorted markets - then crudely, now exquisitely). With downdraws of 35.0% and 33.1% respectively, these short-term events feature exotic causes that essentially blindside the market but nonetheless undergo rapid repricing. Finally, in the long and shallow brown bear category is the 1980 Volker decline, an extended 20.5 month affair where markets grappled with a transition in inflation and interest rate policy - not too dissimilar from our present environment.

With a 24.1% drawdown in 5.5 months, the 2022 H1 bear market does not fit cleanly into any of these four profiles. While most similar to the short and shallow black bear archetype, the most recent decline was longer and deeper than this “correction plus” model. The chart below illustrates that, the Covid and 1987 crashes excepted, bear markets do not see wealth vaporise overnight but instead are somewhat protracted affairs with numerous counter rallies; there is time and opportunity to avoid rash decision making.

The most psychologically punishing aspect of a bear market is, however, not the losses themselves but the potential to miss out on an ensuing recovery. Bears do indeed bounce; some of the best returns in financial history follow bear markets, and forgoing these opportunities can be devastating. For instance, the Russell 3000 rallied up to 18.5% from its June 16th low, a 58% retracement, within a span of 40 trading days; this rate of recovery is 19 times higher than the long-term expected returns for equities.

As the first table depicts, time to recovery following a bear market has a median value of 92 trading days (average is 308 days), and these upswings can be tremendous. The rightmost column shows the annualized rates of return during historical recovery phases, which reached 99.3% and 132% for median and average rates of return, respectively.

When considering bear markets, loss aversion often dominates investor psychology, leaving the consequent rebounds underappreciated - indeed bear markets are small price to pay for a 68-fold increase in value over a 42-year history. This renewed perspective suggests that rather than rouse fear, perhaps bear markets should be regarded as harbingers for elevated return potential on the road ahead.

For more information on the Russell 3000.