By Tim Farrelly 7 Dec 2022
While equities do outperform in the long-term, the price we pay are the periodic bear- markets that test our staying power; panic selling during a bear-market turns long-term
outperformance into underperformance.
This SPOTLIGHT is a guide to help investors survive bear-markets. It looks at the historical evidence back to 1967 to address some key questions. Are we at the beginning or close to the end of this bear-market? What if the global economy moves into recession? What are the best strategies to avoid being hurt during a major equity market downturn? And more.
We begin in Figure 1 with the data on average bear-markets from Australian, US, Japanese and UK equities since 1967. Here we define bear-markets as a fall of at least
25% based on month end data.
A quick scan of this table tells us a lot;
• We should expect to see a major bear-market roughly once every 9 years - long enough for investors to forget the lessons of the previous fall;
• The average fall is large - around a 40% loss of capital. To put that in context, a 40% fall requires a 66% gain in order to get us back to the starting point;
• Falls can be much larger than the average; the worst ever falls in each market were –81% in Japan, -71% in the UK, -55% in Australia and –53% in the US.
Furthermore, the time taken to recover also varied dramatically from case to case
• Markets fall quickly but recover slowly. While the average fall takes around 18 months, the average recovery takes 8 years; 6.5 years if we exclude Japan which
have had much worse falls than other markets over the past 55 years
Also, in Figure 2 at the end of the report, we show the valuation status of each of the individual bear-markets in our sample at the time the downturn began. Of these, 17
bear-markets began when a market was overpriced, six occurred when markets were fully priced and two started when markets were fairly valued. No major bear-markets
began when markets were cheap.
Minimizing the pain that bear-markets cause
Bear-markets are painful. And dangerous. However, there are several steps that investors should take to ensure the damage is minimized.
Don't panic!
This is the most important step. And, in some ways, the hardest to execute. It's all well to say "don't panic" but that is easier said than done when your life savings seem to be
disappearing before your eyes. Furthermore, bear-markets do not occur in a vacuum; the shocks that generally trigger bear-markets are very real and it is not difficult to
imagine the worst when we are in the middle of a crisis. However, what we do know from history is that the long-term impacts of shocks rarely come close to our worst fears.
Panic selling is natural but almost always end in disaster. During the panic phase of a bear-market, prices have generally fallen by between 25% and 50% - selling at that time
means we are locking in these losses forever - panic sellers rarely buy back at lower prices.
The two keys to avoiding panic selling are to understand historical bear-markets and to make sure that you can handle the sort of damage that bear-markets can deliver.
Understand that in a bear-market a portfolio with 100% in growth assets is likely to fall by somewhere between 30% and 50% at least once every ten years. A portfolio with 50% in growth
assets is likely to fall by 15% to 25% at least once every ten years. Can you handle a 50% fall? A 25% fall?
Be diversified
During equity bear-markets, we mostly see all markets fall which leads many to conclude that diversification doesn't work. Nothing could be further from the truth. What actually
happens is that some markets have substantial falls while others have minor falls. Diversification among markets still has the power to limit the size of the downturn.
Avoid overpriced markets
The correlation between severe bear-markets and overpriced markets is well known. Many believe that market over-valuation cannot be identified in advance. We
strongly disagree but recognize that valuation analysis has its challenges - not least of which is the fact that the time lag between a market becoming overvalued and
entering a bear-market is very, very variable. Valuations are not a timing tool.
Ignore market timing
Over and again we see evidence that market timing is really difficult. Bear-markets some times hit well before a recession and recover before the recession is over. At other times
markets continue to fall well beyond the end of a recession. Similarly, markets sometimes fall when interest rates are rising, sometimes they fall. Even if we knew when a recession
will strike or when interest rates will rise, it often does not help with market timing.
Rebalance before the crisis has passed
During the final panic phase of a bear-market, prices often overshoot on the downside as investors dump shares regardless of value. During the panic phase, investors are
normally well below their target exposure to growth assets, either because the value of their growth assets has fallen much more than their defensive assets or because they
had reduced their exposure to growth assets in advance of the fall. In either event, there comes a time to buy back into these assets, ideally at very attractive prices. The
challenge is when to make this move? Do we wait for the economic environment to become clearer? For interest rates to start falling? For valuations to become attractive?
From farrelly's experience we would say no to all three - and particularly the first. Inevitably, by the time that the crisis that triggered the downturn has passed, or that the
economic outlook is becoming brighter, prices will have risen substantially above the lows. The opportunity to re-invest at bargain prices will have passed.
Take an incremental approach to re-investment. This not only ensures that you get reset, it is also good for investors' mental health. The latter is critical at a time that is
highly stressful for all investors. If we only get partially set before the market bottoms, we have the comfort of knowing we have at least secured some bargains and that the rest
of the portfolio is recovering. If markets continue to fall, we know we have only partly committed and can now take advantage of better and better bargains.
If you are interested in the full version of this SPOTLIGHT, contact your adviser, Steve Blizard (email steve@blizard.com.au )
No comments:
Post a Comment