Lessons from a Prior Bull Market Peak

It can be hard to fathom in the depths of a crisis, but bull markets follow bear markets and often erase the declines sooner than most anticipate.

In 2007, global equity markets peaked and one of history's worst bear markets began. At the time, there was little hint of the panic to come. Declines were gentle, and banks weren't yet taking huge (and unnecessary) balance sheet write-downs. But a year later, the fallout extended as banks drastically marked down illiquid securities and the US Fed and Treasury responded haphazardly. The economy felt the impact and panic was spreading. Autumn 2008 and the following winter were harrowing for most investors. From the peak to the 9 March 2009 trough, the S&P 500 Index fell 55.3%.[i] In the darkest days, some felt like equities would never rise again. Many feared their investment goals were finished. Yet years later, equities erased the decline and then some. Whilst that doesn't make the memories of that bear any less painful, it does highlight a key lesson: If you have a long investment time horizon, staying invested through bear markets shouldn't put your longer-term goals out of reach.

The equity market volatility during the 2008 – 2009 bear market was gut wrenching, and it seemed like anything—or nothing—could trigger it. Some people worried the entire equity market could go to zero. Some investors likely sold their equity in search of anything that seemed less susceptible to the madness—cash, fixed interest, gold, annuities, you name it. Yet whilst this might have felt better immediately, it overlooked a simple truth: Bull markets follow bear markets. Investors may feel the urge to do something during market volatility or bear markets, but this desire to act can compromise your financial goals.

In our view, losing sight of this can be dangerous. Depending on your time horizon and cash flow needs, participating in a bear market isn't necessarily devastating. However, in our view, abandoning equities after participating in a bear's deep declines locks in losses and raises the risk that equity prices snap back before you get back in. In the industry vernacular, you could get whipsawed—feeling the losses on the downturn and missing the sharp, initial rebound.

Participating in bear markets needn't be a permanent setback, provided you also participate in all bull markets. This concept is hard for many investors to fathom: When the subsequent bull began in 2009, many feared a "new normal" of below-average equity returns. Since it takes a higher percentage gain to offset a given loss, a "new normal" recovery raised the spectre of going decades without recouping losses.

Even if you didn't buy the "new normal" idea and were considering only equities' average annualised return (around 10% since 1926),[ii] you might still have expected to take a decade or more to recover fully. But these average returns include all bear markets, and most of the time, equities’ actual annual returns are more extreme than the long-term average. Gains often come in clumpy patches, and since bear markets usually end with a V-shaped rebound, some of the biggest clumps can occur early in a bull market, speeding the time to recovery and surprising many. For instance, from the 9 March 2009 trough through year end, the S&P 500 gained 68%.[iii] Other recoveries have bounced fast and high, too—with new equity market records coming a within a few years, sometimes months.

Exhibit 1: US Equities’ Rebound After 2007 – 2009 Bear Market

Source: FactSet, as of 15/11/2018. S&P 500 daily price returns in USD, 09/10/2007 – 28/03/2013. International currency fluctuations may result in a higher or lower investment return.

The bull starting in 2009 took about four years to pass the prior peak, as Exhibit 1 shows. (Factoring in dividends shaves this to three years.) Four years might seem like a long time as you're living it, but if you're investing for the next 15, 20, 30 or more years, it looks relatively shorter.

This is why we believe the time to act is early in a bear—or not at all. Signs of an early-stage bear—a major, fundamentally driven market decline of at least 20%—include cresting euphoria that ignores deteriorating fundamentals, or an unseen, multitrillion dollar negative suddenly walloping the global economy and equities. We don't think it's required to side-step bear markets if you're investing for long-term growth, but it can help. But the key is identifying a bear market shortly after it forms. After equities have endured significant drops, we generally think the risks of getting out outweigh the risks of staying in. Selling later in bear markets can open you up to potentially getting whipsawed!

Now, this doesn't mean there is a cookie-cutter strategy that is right for all investors. What is right for you always depends on your unique circumstances, investment time horizon, cash flow needs and goals. But for investors whose investment time horizons are sufficiently long and who don't have high cash flow needs currently, enduring bear markets doesn't have to be a permanent setback. Bears loom large in memory because they're so emotionally painful, but they don't loom so large in equities’ long-term returns.

[i] Source: FactSet, as of 06/10/2017. S&P 500 Total Return Index in USD, 09/10/2007 – 09/03/2009. International currency fluctuations may result in a higher or lower investment return.

[ii] Source: Global Financial Data, Inc., as of 06/10/2017. S&P 500 Total Return Index in USD, 1926 – 2016. International currency fluctuations may result in a higher or lower investment return.

[iii] Source: FactSet, as of 10/6/2017. S&P Total Return Index in USD, 3/9/2009 - 12/31/2009. International currency fluctuations may result in a higher or lower investment return.

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.