Sharp market declines are never pleasant. This is especially true when U.S. equities enter bear market territory. The volatility can become so distressing that investors may feel compelled to exit risk assets at precisely the wrong time.
With that said, let’s look at the latest coronavirus-induced drawdown and compare it to a history of drawdowns, both in time and in percentage decline. I believe this will allow us to better understand when this drawdown may end and how quickly a recovery might take place.
A History of Bear Markets
History teaches us that drawdowns tend to fall into one of two categories: sharp and short, or longer and deeper. The current drawdown has been quick, and in our industry a quick drawdown is called a “waterfall.” Traditional waterfall drawdowns are signs of panic, market dislocation, fear of an unforeseen paradigm shift, or a combination of these. Other drawdowns take longer to complete and are typically associated with market or financial excess. Significant drawdowns associated with excess include the tech bubble and burst of 2002, the nifty-fifty bear market of 1974 and the financial crisis of 2008. Each of these drawdowns lasted between one and two years, with markets taking time to work off the significant overvaluation that had developed leading up to their peaks.
It must be noted that markets have recovered from every bear market, whether waterfall or longer-lasting, up to this point. In other words, all past crises (and overvaluations) have eventually been put behind us. It should also be noted that the length of the bear market also provides some clues as to the length of time it will take to recover from them.
If one uses history as a guide, it would seem that this current bear market will end in a quick recovery. But the market will likely need to see through the worst of the virus and economic data before bottoming. We are seeing extraordinary efforts on the part of central banks and governments around the world to help ensure that markets keep functioning and the damage to the world and U.S. economies are mitigated.
We continue to believe that the most likely case is for a V-shaped recovery. But the resulting weakness may be deeper and longer-lasting than originally estimated and the likelihood of a global recession has risen. We do expect that the economic strength of U.S. economy prior to the virus will help the nation as we eventually rebound from this weakness. We believe that equity markets will recover before the economy does.
The Danger of Market Timing
While the volatile swings are unnerving for investors, being out of the market and potentially missing some of the best-performing days, can prove costly. As history suggests, best days often directly follow the worst days, a phenomenon we’ve seen occur twice in the last two weeks.
The following chart quantifies the cost of selling after declines and not fully participating in the ultimate recovery. If we look at the last 20 years, a period that included two bear markets and two bull markets, you can clearly see the advantage of staying invested, as represented by the 5% annual total return. If an investor missed the best 10 days, his or her total return is drastically reduced, losing 4% annually. If you miss the best 30 days, annual returns turn negative. It can be very dangerous for long-term investors to try to time the market, especially in volatile periods such as this.
What We Are Recommending
Remain Disciplined: Rather than trying to time the market, try to stay disciplined to a well thought-out plan that is aligned to your goals.
Implement Our Best Thinking: Within our diversified portfolios, we continue to recommend a neutral equity stance with an emphasis on U.S. large cap stocks. We are using market weakness to move up in quality, by shifting away from international developed large cap equities to domestic large cap equities, as we expect the latter to continue to deliver better relative performance. We also recommend a modest increase to opportunistic fixed income in light of current market dislocations.
Incorporate Additional Downside Protection: While our diversified portfolios incorporate both fixed income and lower correlated strategies as a cushion against drawdowns, some investors may want to explore buffered equity solutions to help provide additional protection from further downside.
Bottom-Up Opportunities Being Created: In the midst of the volatility, correlations among stocks in the S&P 500 are approaching one, meaning that there is a lot of indiscriminate selling regardless of fundamentals. As a result, our sector analysts are seeing many bottom-up opportunities to buy high-quality companies, with strong business models and/or a history of strong dividend growth at extremely attractive prices.
We recognize that uncertainty around the COVID-19 pandemic is unprecedented and we will, in our opinion, have more volatile days ahead of us. But, using history as a guide, we know that this downturn will eventually end. With so much downside damage in such a short amount of time, this will likely be a better entry point than exit point for investors with a longer-term time horizon. As history shows us, investors don’t want to be out of the market and miss the dramatic up days that often follow down days, as these can prove costly and keep you from reaching your goals.