Big bears or baby bears?

This period of unusual volatility will separate investment managers from just asset gatherers…with risk management expertise being key.

— Mohamed El-Erian

I saw the above quote on LinkedIn this past week. It hit me as the perfect description as to how I would describe the difference in what my team attempts to do and what our portfolio managers at Manulife Investment Management endeavor to do on a daily basis on behalf of our clients — that is, manage risk, stay disciplined to our respective processes, and work to achieve our clients’ objectives. In other words, we fulfill our roles as investment managers.

I responded to the post with the following comment:

The easiest thing in this business is to always be bullish and hold to “buy the dip.” The probabilities suggest we would be successful 70% of the time (equities are up approximately 70% of the time over a 12-month period, as measured by the S&P 500 Index since 1927).

The hardest thing to do is to sell, take a profit and forgo further gains because the fundamentals just ain’t so. Holding to your process and letting the fundamentals be your guide is the true difference between being an investment manager or an asset gatherer. It is the difference between great and mediocre. Which would you rather be?

We characterize bear markets as periods where the peak to trough decline is greater than 19% whereas the accepted definition is greater than 20%.  We have made a slight change as the bear markets of 2018, 2011 European Debt Crisis and U.S. Deb downgrade, Asian Currency Crisis, 1990,  1980, 1976 Bear Market would not be included in analysis of bear markets since their peak to trough drops were only -19.8%, -19.4%, -19.3%, -19.9%, -19.7%, -19.3%.  We thought it was important to expand the traditional definition of bear markets to include these periods.  Since 1970, there have been 11 bear markets (peak to trough losses greater than 19%).  Of the 11 bear markets, 6 had a recession occur during them and 5 did not.  Bear Markets with recessions which much more severe.  On average, Bear Markets with recessions saw an average peak to trough decline of 40% whereas bear markets without a recession saw an average decline of 22%. On average, a bear markets wrapped in a recession has 20 percent more downside than a bear market that does not. As of the end of March, 3.38 billion people worldwide have been asked or ordered to follow confinement measures in the fight against COVID-19, that’s more than 4 in 10 people worldwide!  These mitigation measures will lead to a global recession over the upcoming months.  The COVID-19 bear market has seen a peak to trough decline of approximately 35% before rallying nearly 15% from it’s recent low.  Have we created a bottom? Based on historical analysis, we believe that there is likely further downside from here although we believe that we have experienced the majority of the decline.

If we establish that this is a recessionary bear market and if we are avoiding the buy-the-dip mentality that has permeated (and admittedly rewarded) investor behavior over the past ten years, then we need to consider at what level from the peak should we start considering adding back to equities, assuming the fundamentals are supportive, of course.

To examine this, we took a look at past recessionary bear markets and segmented returns 1, 2, and 3 years following equity declines of 10%, 20%, 30%, 40%, and 50% from the peak. The following heatmap identifies the buying opportunities in each period. What we notice is that, in deep bear markets (2008–09, 2000–02, and 1973–74), the true buying opportunity (whereby gains were had 1–2 years out) didn’t occur until equities were -30% or more off their respective peaks. In shallower bears (1990–91, 1980–82, and 1970), the buying opportunity came sooner, following drops of 10%. We believe this is likely to be a deeper or big-bear market, as mentioned above. As such, the table below highlights that, during recessionary bear markets, it is prudent to wait and not simply rush into the market at the first dip. The real payback appears to occur when equities are down 30% or more.

During previous recessions, how did investors fare investing in the S&P 500 Index declines of  -10%, -20%, -30%, -40% and -50% from the peak?  The table above illustrates investor’s 1 year, 2 year and 3 year total forward returns at increments of -10%, -20%, -30%, -40% and -50% from the peak during the past five recessions.   For example during the Great Financial Crisis, an investor who invested in the S&P 500 Index once it fell -20% from its peak achieve a total 1 year, 2 year and 3 year forward return of -29%, -19% and 6% respectively.  The table above highlights that during recessionary bear markets that it’s prudent for investors not to rush into the market if it’s down -10% or -20%.  The real payback comes when the markets are down -30% or more.

Lastly, we need to attach realistic timelines to the equity market recovery. There is a belief that equity markets will rebound quickly following a resumption of normal economic activity. I have even heard some speculate that the market can reach its prior peak by year end. We are not of that belief for two reasons. First, we would argue the fundamentals didn’t justify markets being at the February levels to begin with; therefore, a return to overvalued levels is less likely. And second, from a historical perspective, a sharp equity market rebound is rare. Market commentators like to attach letter shapes to the economic or equity market recovery — I have heard of V, U, W, or L-shaped recoveries. While we don’t subscribe to these definitions, if we had to, we would say the equity market recovery might look like a V that has lost its energy — that is, a sharp decline met by a flatter sloped recovery, or rather, a longer-dated and gradual pay-back period. Investors would be wise to keep this in mind when setting expectations.

We highlight how long it took for investors to break even on their initial investment once the markets had bottomed during previous recessionary and non-recessionary bear markets. The chart below illustrates the median and average trading days it took for an investor to break even after investing at drops of 10%, 20%, 30%, 40%, and 50%. For example, after a drop of 10% from the peak, on average, it took approximately 730 trading days to break even from a recessionary bear market versus 138 in a non-recessionary environment. There are approximately 250 trading days in a year, so this suggests an investor who bought at the first 10% dip during a recessionary bear market may not see a return on that investment for almost three years.

We believe the conditions are consistent with a recession and, as such, would put this bear market into the recessionary camp. Markets don’t move in straight lines; we should anticipate bear-market rallies in prolonged dislocations subsequent to which old lows will either be retested or broken. We should also be realistic about the recovery period for stocks. During the dot-com crash, we experienced six different bear market rallies (a rally of greater than 20%) within the ultimate pullback of 49%. Too many believe we will recover by the end of the year. History doesn’t show that. But what it does show is that from these levels, investors do see gains 1, 2, or 3 years out.

It is for these and other fundamental reasons that we are starting to hold equities in a more optimistic light. And while we still maintain an overall underweight to equities in our model portfolio, as of this quarter, we are starting to take advantage of the price dislocation and have shifted 5% from fixed income to equities. Our current model portfolio asset allocation, as at the end of the first quarter, now stands at 55% equities and 45% fixed income. The opportunities are not without a cost. At this time, we believe the cost is patience. We also believe that patience will be rewarded.

During previous recessions (Great Financial Crisis,, 1990, 1980, 1973/1974 and 1970) how long did it take for investors to breakeven on their initial investment once the markets had bottomed? The above table illustrates the  median and average trading days it took for an investor to breakeven after investing at -10%, -20%, -30%, -40% and -50%.     For example, after a drop of -30% from the peak, on average it took approximately 230 trading days to breakeven and the median number of trading days to breakeven was approximately 200.  Market don’t move in straight lines, one should anticipate bear market rallies in prolonged dislocations subsequent to which old lows will either be retested or broken.  One should be realistic about the recovery period for stocks.  During, we experienced six different bear market rallies (a rally of greater than 20%) within the ultimate pullback of 49%.  Too many believe we will recover by the end of the year- history doesn’t show that.  But what it does show is that investors are up 1, 2, or 3 years out from these levels.

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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