The stock sell-offs of the past month have worried many investors. With long-time Wall Street darlings like Amazon down 20% in the month of October, it’s normal to be wondering things like, have we finally crested the top of this decade-long bull market? Should I get out of stocks entirely? Is a crash coming?

While neither we nor anyone else can answer these questions definitively, we can address the concerns that generate them by providing historical context for market behavior like October’s. The historical data show that declines in stock prices when the economy is expanding (as it is today) are virtually unforeseeable. However, the data also indicate that many of the biggest stock draw-downs coincide with recessions and can therefore be anticipated – and possibly avoided – by carefully monitoring recession indicators.

A correction or bear in the making

With a decline of 9.87% from the S&P’s all-time closing high of 2,930.75 on September 20 to the most recent closing low of 2,641.25 on October 29, the S&P 500 fell just short of what is called a “correction.” Corrections are sell-offs in which stocks’ prices decline by at least 10%, but less than 20%, with respect to a recent high. Corrections typically indicate that investors are having doubts about whether stock prices are justified or whether recent bullish (increasing) price trends are sustainable. The sell-offs caused by those doubts create “cooling off” periods during which investors re-evaluate the prior high prices levels and decide whether stocks should return to those valuations. By definition, corrections conclude with a subsequent recovery, in which investors ultimately decide to continue buying stocks, causing prices to return to and exceed their previous highs before a decline of 20% is realized. Since the last bear market of 2008-2009, U.S. stocks have experienced five corrections:

  • the 16% drop of 2010,
  • the 19.4% near-bear market correction of 2011,
  • the 12.4% decline in 2015,
  • the 13.3% decline in early 2016, and
  • the VIX meltdown of February 2018.

All of those corrections jarred investors’ confidence in the market and in the safety of their investments. In each of these instances, however, the market ultimately recovered and surpassed its pre-correction high. That is why they turned out to be, and are remembered as, corrections, not their far more nefarious cousins, bear markets.

Bear markets occur when stock prices decline 20% or more. While the correction and bear market thresholds (10% and 20%) might appear artificial, they are important because they tend to produce different changes in market psychology – that is, the cumulative perception and opinion of millions of investors and speculators whose trading activities drive stock prices. Unlike corrections, which provide transient cooling off and price reassessment periods, bear markets signify intense and pervasive investor pessimism in the underlying fundamentals of the financial markets and sometimes the entire economy. While all investors would like to avoid corrections and bear markets alike, they particularly seek to avoid bear markets. The three most recent bear markets – of 1987, 2001-2003, and 2008-2009 – saw drawdowns in the S&P 500 of 33.5%, 49.1%, and 56.8%, respectively.

The impact on wealth

To illustrate the severity of bear markets’ wealth destruction, imagine that you had invested a lump sum of money in the S&P 500 on January 1, 1987. If you never traded the principal, but had continuously reinvested the dividends in the S&P, your investment would have realized an annualized return (assuming no taxes or commissions were paid) of 8.8%. If, however, instead of merely “buying and holding,” you had managed to sell your position in the S&P near the highest price levels preceding each of the three bear markets, and had reinvested the value of your lump sum in the S&P near the lowest price levels of those bear markets, your annualized return, with dividend reinvestment, would have been 14.5% (again, gross of taxes and commissions). In other words, instead of having a little more than 14 times your initial investment, today you would have 75 times your lump sum from 1987, or five times the multiple produced by a “buy and hold” strategy.* The wealth destruction of bear markets and the compounding effects of time account for the difference.

A better way than random chance

Now, a well-diversified portfolio includes U.S. stocks in addition to other asset classes, including international stocks and bonds of diverse provenance, so this discussion presents the returns of only one component – albeit usually a large one – of investors’ portfolios. It nonetheless behooves investors to figure out whether a stock sell-off like October’s will turn out to be a correction – in which case the market will, before dropping yet another 10%, rebound and surpass the recent high – or will decay into a bear market. Just because U.S. stock indexes have recovered slightly over the last week of trading sessions does not mean they cannot reverse course and resume their downward march.

Perhaps the best way to anticipate a bear market – not time it precisely, which, I should emphasize, is impossible to do on the basis of foresight and skill alone, as opposed to luck – is to observe from the historical data that seven of the ten bear markets of the past seventy years have coincided with economic recessions. (The three bear markets that occurred during times of economic expansion – 1962, 1966, and 1987 – were, for this reason, like their expansion-concurrent correction cousins, quite simply unforeseeable ex ante). And every one of the 11 U.S. economic recessions since 1948 has coincided with either a bear market or a correction. This matters because while it is impossible to reliably time bear markets or corrections, it is actually possible to monitor and heed the kinds of changes in the underlying U.S. economy that are likely to produce the most severe stock sell-offs. In other words, by monitoring economic data that signal a recession is in the offing or underway, investors stand a better than random chance of being able to avoid some of the biggest draw downs in the stock market, which is not to say – as the bear markets of ’62, ’66, and ’87 show – all of them.

Skill in timing the market does not exist, but skill in anticipating recessions most certainly does.

In my next post, I’ll elaborate on how monitoring recession signals would have prepared investors for the recession-concurrent bear markets of 2001-2002 and 2008-2009. I will also discuss the particular economic indicators we are monitoring to keep our finger on the pulse of U.S. stocks and judge the likelihood that the recent sell-off will devolve into a full-fledged bear-market.

 

* To calculate the return of the back-tested bear market avoidance strategy, I used the highest closing monthly value at the beginning of a bear market and the lowest closing monthly value at the bottom of a bear market. What this means, however, is that I did not use the absolute highs preceding or absolute lows during a bear market. For example, instead of using the pre-financial crisis closing high of 1565.15 reached on October 9, 2007, I used the October 2007 closing price of 1549.38, and instead of using the famous 2008-2009 bear market absolute intraday bottom of 666, realized on March 9, 2009, I used the February 2009 closing price of 735.09. Therefore, my methodology understates slightly the wealth destruction of bear markets.

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