A Historical Look at Bear Market Recovery
THE RUBBER BAND BOUNCE BACK
[Ernie Ankrim, Director of Portfolio Research] Ernie Ankrim, Ph.D.
Director of Portfolio Research
Russell Investment Group
Think of a rubber band stretched horizontally between two fingers. If
you pull the rubber band lower, it forms a V shape. But let go and it
snaps back to horizontal. Likewise, if you pull the band higher it
forms an inverted V, but only until you let go. Either way, the rubber
band has a resiliency to bounce back to its "natural" state.
Historically, the U.S. stock market has behaved much like a rubber band
and that's worth remembering in both bull and bear markets. It
also explains why investors compound mistakes when they panic and sell
out during a down market. One of the least understood characteristics
of the market is its historical tendency to bounce back from down
periods.
Recessions occur when the economy slows, typically dragging corporate
earnings lower. If the stock market responds by declining more than 20%
from top to bottom, as measured by the key benchmarks, then some market
analysts say that a "bear market" has developed. However, there is no
universally accepted definition for the term. What is certain is that in
every bear market of the past century, U.S. stocks have demonstrated
the capacity to bounce back, according to a Frank Russell study of
long-term performance. In fact, a significant bounce-back has usually
occurred within one year of a market bottom.
As the oldest stock benchmark in the world, the 118-year-old Dow Jones
Industrial Average1 (DJIA) offers a window on performance over the past
century. It shows that the U.S. stock market has endured 19 periods in
which the index has dropped at least 20% from top to bottom. The most
recent began in January of 2000, when the DJIA peaked at 11,723. Through
mid-March of 2001, the index had declined by 22.3%. Broader market
measures like the S&P 5002 and Russell 1000®3 peaked later, but fell
harder. Both indexes peaked in March 2000 but recovered to near peak
levels in September. Over the next seven months the Russell 1000®
fell 24.3% and the S&P 500 fell by 23.0%. This was the first bear
market since 1990, when an era of great investment market growth began.
In other words, it was the first "bear" that many investors have seen
first-hand.
The Story of 19 Bears
It may be too soon to know whether a true bottom was reached this past
March. But in any case, history suggests that the resiliency of the
market should not be underestimated. This is shown in the chart below,
supported by these observations:
* The average decline in the DJIA during the 19 previous "bear
markets" was 37%.
* In the years following the bottom of these 19 bear markets, the
DJIA had an average annual return of 40%.
* The S&P 500 Index has been published since the 1920s as a broader
measure of U.S. stocks than the DJIA. This index corroborates results
during the past 13 bear markets (not counting the current one). The S&P
500's average annual return in the years following bottoms was 44%.
Most importantly, in every year since 1900 after a decline of at least
20% in the DJIA, stock market returns have been positive. The graph
below shows each period since 1900 in which the Dow has declined more
than 20% and the average's annual return in the year following the
decline.
Source: Analysis is by Russell using data produced by Dow Jones.
Why the Market Is So Resilient
Does the U.S. stock market have a built-in "bounce-back" quality like a
rubber band? History supports that thinking. But why?
The best explanation may be that long-term stock market performance
depends on two factors: 1) overall economic growth; and 2) corporate
profits. The U.S. stock market's historic long-term rate of growth is
about 11% per year, and that is approximately the same annual rate at
which corporate profits have increased. During a bullish period like the
late 1990s, profit growth accelerated somewhat, but stock prices surged
much faster. As a result, stocks became "overvalued" relative to
historic prices. The bear market of 2000 showed that the downward
resiliency of the market is intact. In effect, the rubber band had been
stretched too high and it snapped sharply back down.
But now, the relationship between corporate profits and stock prices is
more in line with historic averages. Some sectors of the market now
appear to be priced in line with earnings growth prospects. Although
it's impossible to know whether this bear market will become a historic
exception, investors can expect that market returns over time will
continue to be influenced by economic growth and profits.
How to Apply Historical Results
Here are points to keep in mind in applying our study of how the market
historically bounces back from downturns.
* It's easier to predict a market bounce-back than a market bottom.
>From top to bottom, bear markets have lasted as long as three and a
half years or as short as two months. By definition, prices can always
go lower in a bear market. It's only with hindsight that investors can
identify the bottom.
* In most bear markets, some price losses occur when some investors
panic and sell out irrationally. During the bounce-back, some of these
same investors move back into the market (usually at higher prices).
* Bear markets include a degree of pessimism about the future of
economic growth and corporate profits. It's important to remember that
there are major long-term economic drivers present in the U.S. economy,
ranging from immigration to tech-driven productivity. When confidence
in the economy begins to return, bounce-backs can happen quickly.
* Historically, bear markets have occurred about once every five or
six years. The last period without a bear (1990-2000) was unusually
long. A smart investor expects a difficult market every few years and
"prepares for the bear."
* The best way to prepare is to develop a realistic plan for
achieving strategic long-term goals, based on historic market returns,
and then diversify across asset classes.
* When the bear hits, hunker down and wait it out. If you are
investing systematically (i.e., dollar cost averaging), try to maintain
your program. If and when the bounce-back occurs, shares you purchased
at the bottom will look like bargains.
Finally, remember this. While it's a good idea to be an informed
investor, economic information can be hazardous. During bear markets,
there are pervasive bits of negative news and gloomy forecasts which
might entice investors to give up on stocks in their investment
strategy. Similarly during bull markets, analysts are optimistic,
economic forecasts are buoyant and investors are encouraged to get out
of boring investments, like bonds, in order to enjoy the great rewards
of stocks. Investors who have resisted the lure that these extreme
environments bring can better avoid the costs of the market bounces,
whether they are bear-market adjustments to over-enthusiasm or
bull-market adjustments to pervasive pessimism.
The best way to cope with this, or any bear market is to develop a
portfolio that focuses on your personal long-term goals, feels
comfortable in terms of risk, and is well diversified across asset
classes, styles and managers. Then, trust your plan and stick with it.
1Dow Jones Industrial Average: Price-weighted average of 30 actively
traded blue chip stocks.
2S&P 500 Index: (1) An index, with dividends reinvested, of 500 issues
representative of leading companies in the U.S. large cap securities
market. (representative sample of leading companies in leading
industries)
3Russell 1000® Index: Measures the performance of the 1,000 largest
companies in the Russell 3000® Index, representative of the U.S.
large capitalization securities market.
Frank Russell Company and Standard & Poor's are the owners of the
trademarks, service marks and copyrights associated with their indexes.
Indexes are unmanaged and can not be invested in directly.
Past performance is not indicative of future results.
Frank Russell Company, one of the world's leading investment management
and advisory firms, provides investment advice, analytical tools and
funds to institutional and individual investors in more than 35
countries. Russell's investment management business employs a
manager-of-managers approach and has approximately $60 billion in
assets under management. The company has retainer consulting
relationships with clients representing more than US $1 trillion
worldwide. Frank Russell Company became a subsidiary of The
Northwestern Mutual Life Insurance Company in January 1999. Founded in
1936, Russell is headquartered in Tacoma, WA, and has offices in New
York, Toronto, London, Singapore, Paris, Sydney, Auckland and Tokyo.
Copyright © Frank Russell Company 2004. All rights reserved.
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Date of first use: 4/25/01.
