The full PDF of this report is available for download below.
Today we release the second in a series of Bear Market Anatomy reports. We find these reports useful for preparing for what to do when the market falls 15%. Today's deck on Emerging Markets, like the previous deck on Canada and future decks on Europe, Japan, the UK, and the US, is not a forecasting tool.
At a very high level, every deck reaches the same three conclusions:
By the time a bear market can be identified (defined in our reports as a 15% drawdown), the median remaining fall is small (4% to 11% depending on the market).
That the deep drawdown cases (typically structural bear markets) cannot be picked out in advance, and
Our Bull/Bear composite does not time tops.
Put another way, investors can use the decks to set their own response rules, in advance of a decline, with a rough idea of the shape of a potential decline. They are not a tool for predicting when a bear market will start. These documents present only history and, in doing so, provide only an interpretive framework for analysis; you must bring flexibility in how you deploy the information.
A Few Potential Use Cases for an Individual Investor
A Drawdown Policy Written Before the Drawdown
The recognition statistics (pages 15-19 in the EM Report linked below) might be the most useful material in the series, in our opinion. Recognition occurs at the first close 15% below the peak, the earliest date a bear market (as we define it) can be identified in real time.
Median further fall after recognition | Higher 12 months after recognition | |
|---|---|---|
US | 4% | 11 of 15 |
Canada | 8% | 11 of 16 |
UK | 7% | 9 of 11 |
Europe (STOXX 600) | 11% | 11 of 13 |
Euro area | 10% | 12 of 16 |
Japan | 6% | 15 of 21 |
EM | 7.5% | 14 of 22 |
With these numbers in hand, you can write down two rules:
What will you do on the first close at 15% down?
What will you do if the market falls a further 10%?
For example, that might mean adding 25% to your positions at recognition and adding a further 50% after a further 10% fall.
What Normal Volatility Looks Like
The intra-year drawdown slide (page 14 in the EM presentation) is the best behavioral calibration material in the deck. The median drawdown inside a calendar year is 11% in the US and Canada and 19% in Japan, yet in 39 of 47 US years this occurred, the US markets still ended higher. Given recent drawdowns of ~9% and 13% in the S&P 500 and Nasdaq from inter-year peaks, this might even prove useful information this year.
A 10% drawdown alone is weak grounds for selling. We suspect it is also where individual investors do most of the damage to their own returns.
Sizing for the Tail
The two structural bear markets (2000-02 and 2007-09) took between 50% and 66% off every market we studied. The US took roughly four years to regain its peak on price, the STOXX 600 took 12 years after 2000, and the 2000 peak has still not been regained in real terms in either European index we examined. For a retiree, or anyone drawing an income from the portfolio, that creates a sequence-of-returns and liquidity problem, rather than a valuation problem.
Measuring Recovery Properly
Dividends can shorten the wait considerably, from 20 months to 13 in Canada and from 31 to 16 in Europe. Inflation lengthens it; after 2008-09 the TSX took 143 months to regain its peak in real terms. Individual investors almost always look at price charts, so this changes the answer to the question they actually ask: how long until they are whole.
Does Diversification Work? Don't Forget Currency
Japan fell less than the S&P 500 in 27 of 31 US corrections and makes its own bear markets; the UK fell less in 16 of 20. Europe and the euro area are a different story, falling further in 8 of 20 corrections respectively (both structural bears included), and EM fell further in 9 of 18.
Currency matters as much as country, since a third of the average EM bear-market losses was currency, and the cushion the TSX offers in Canadian dollars largely disappears once the losses are measured in US dollars.
Nothing in these decks will tell you when the next bear market starts, and we would be suspicious of anyone who claimed they could. The timing of this work might tell you a little about what we think about the future, but please keep in mind our thoughts are strongly stated and weakly held. Nevertheless, we believe a historical review can take most decisions out of the moment when they are hardest to make. Hard decisions with hefty emotional content are best made before that emotional content smacks you upside the face. By the first close 15% below the peak, your pain is very real, your emotions are frayed, but the median market has only 4% to 11% left to fall. Equally important, in every market we studied for this analysis, at least three in five episodes stood higher a year later. The investor who sells at that point has usually locked in most of the loss and missed the recovery.
As Eisenhower is reputed to have said, plans are useless, but planning is essential; we agree. The useful work is done before the drawdown. Decide what you will do at the point of recognition and what you will do if the market falls a further 10%. Accept that a 10% fall within a calendar year is normal and thus not necessarily grounds for any action whatsoever. Measure your recovery by total return rather than price, and check how much of your diversification survives the translation back into your own currency.
