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. Important Legal Information. <http://ei.russellink.com/copyright.asp> Date of first use: 4/25/01.