- Bear markets are generally defined as a peak to trough
decline of at least 20% in the stock market. Bear markets are not fun to live through, but they should be
expected from time to time. Every now and then
uncertainty about the future drives asset prices down, and it usually feels like
things are going to get worse before they get better. The U.S. stock market
has had 27 bear markets from 1900 through March 2020 by my count. That works out to a bear market every four and a half years on average. Even for the most seasoned investor, every bear market is equally unnerving. Uncertainty is hard for us humans. I'm Ben Felix, Portfolio
Manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you why
every bear market is different and why that is not a reason to abandon a properly
diversified portfolio. (bright music) Investing in stocks is risky. Risk is not a flaw in the stock market, it is for taking on the
risk of owning shares in businesses that investors are able to expect positive long term returns. Investing in less risky assets
like bonds is also an option, but the expected returns are lower. This risk-expected return trade off is pervasive in investing. From 1900 through 2019,
global stocks delivered a 5.2% annualized
inflation adjusted return, while global bonds delivered
much more modest 2% over the same time period. That 3.2% annualized difference
might not seem like much, but over 30 years at those rates, a stock portfolio would
increase its purchasing power 2.5 times more than a bond portfolio. Who wouldn't go for that? Lots of people. And I'll tell you why. The challenge with investing
in risky assets like stocks is that despite their
positive expected returns, they tend to be volatile
in the short term. This can make sticking with a
long term investment strategy hard to do. Richard Thaler and Shlomo
Benartzi referred to this problem as myopic loss aversion in
a 1993 paper aptly titled, Myopic Loss Aversion and
the Equity Premium Puzzle. They theorized that
investors are loss averse, meaning they're distinctly more sensitive to losses than to gains, and that they evaluate
their portfolios frequently, even if they have long
term investment goals such as saving for retirement. Myopic loss aversion might
be easier to live with if we always knew how the story would end. Enduring losses with the knowledge that things will be better soon, is a lot easier than
living with the uncertainty of a specific situation. I can't tell you how
the current bear market or future bear markets will end. Uncertainty is tricky like that. But I can tell you how
things have played out after past bear markets and
how uncertain things seemed for investors at the time. I'm using monthly U.S. stock market data because Robert Shiller publishes it on his website going back to 1871, and you can download it there too. Since 1900, the U.S.
has had 27 bear markets. On average the decline has
been 30% from peak to trough, and it has taken 13 months
for that drop to happen. From the bottom, it has taken on average, 27 months to return to the previous peak. I think it's easy to see
those data and think, hey, that's not so bad. I can handle a 30% drop over 13 months and a 27 month recovery. If only it were that easy. When a market drop is happening, you don't get to see where the bottom is. And in most cases, there's
a lot of reason to believe that things will not get better. Here's some past bear
markets with what I think are particularly unnerving causes. During the Panic of 1907, the U.S. stock market
dropped 36% over 14 months. Preceding the drop, the
U.S. had been devastated by the San Francisco
earthquake and fire of 1906. The economic fallout of the earthquake pushed the U.S. economy into
a recession in May 1907. And soon after that the
financial sector crashed. Banks collapsed, including the
Knickerbocker Trust Company, which was one of the
largest banking institutions at the time. A massive natural disaster,
macro economic troubles and a domestic financial crisis, that doesn't sound like a good time. It's easy to look back now and see that the market bottomed
out by October 1907 and recovered by July 1909. But without having that knowledge, enduring the drop would
have been challenging. Moving ahead a few years,
the New York Stock Exchange had closed for an unprecedented
four months in 1914 to avoid a financial
crisis due to the war. Talk about uncertain times. After the reopening of the exchange, the U.S. market rose to a
new peak in October 1916. In late 1917, a nasty flu
now known as the Spanish flu, was sweeping through U.S. military camps. The virus rapidly spread across the globe, probably through the
movement of troops during and after World War I. Around the same time as the
first reported cases of the flu, the U.S. stock market took a steep dive, dropping a little more than 30% from the October 1916 peak to
the trough in November 1917. If we account for inflation, which was quite high at the time, that drop in real terms was closer to 45%. The 1918 flu pandemic had a
huge economic impact globally, reducing GDP by an estimated
six to 8% in a typical country, as interventions similar
to those that we are seeing today were put in place,
restricting economic activity. It seems likely that the combination of public health concerns
and economic uncertainty made this a challenging
time to stay invested. Nobody knew when the bottom would come. An interesting point here is that while the worst of
the Spanish Flu did not come until later in 1918, the
market had already started its recovery by then. The theoretical explanation for
this might be that the worst of the pandemic had already been priced into the market in 1917. Of course, nobody would
have known that at the time. Fast forward to 1929,
after nearly a decade of leveraged speculative
investors driving up stock prices, the stock market reached
a peak in September 1929, plummeted in October and
was down 30% by November. It continued to fall until June 1932, when it reached a peak
to trough decline of 83%. During this massive decline in prices, there was also a severe drought that impacted the U.S.
agricultural output, significant deflation
which discouraged spending and global tariffs reducing trade. U.S. unemployment reached 25% and thousands of U.S.
banks failed in the 1930s. If economic hardship weren't enough, Americans were watching as
communism and fascism took hold in other parts of the world, no doubt raising concerns
about the viability of the American way of life. The bottom came in June 1932, 33 months after the September 1929 peak, but it wasn't a smooth ride back up. If you had invested at the
peak in September 1929, you would have not recovered
your initial investment in nominal terms until
June 1944, 15 years later. Between 1932 and 1944, there
were four other bear markets with peak to trough declines
of 30% in February 1933, 20% in October 1933, 20% in
July 1934 and 50% in March 1938. The 30s were not a fun
time to invest in stocks. I think it's worth mentioning that it took 15 years to recover from the 1929 stock market
crash in nominal terms. But this was a significantly
deflationary period, the price of goods was falling. If we adjust for deflation, the recovery came much more quickly, in about seven years from
the peak in September 1929. A little over four years
from the bottom in June 1932. That's still a long time to recover, but not nearly as daunting as 15 years. The 1930s were particularly turbulent, but we don't have to go far into the 1940s to find our next bear market. The market dropped 28% from
its peak in September 1939 to its trough in April 1942. This decline was punctuated
by Hitler's invasion of Western Europe in May
1940 and the Japanese attack on Pearl Harbor in December 1941. That's the kind of uncertainty
that makes your head spin. At least it makes mine spin. I can't even imagine
living, let alone investing through that type of uncertainty. Only nine months after the bottom, the market was back up
to its previous peak. In September 1974, stocks fell 46% from their December 1972 peak. The U.S. economy had entered
a recession in November 1973 and inflation was surging at the time. That 46% drop in the stock
market was closer to a 60% drop, adjusted for inflation. President Richard Nixon had
taken historic economic measures to combat inflation in 1971, commonly referred to as the Nixon shock, but they ended up failing. Adding to inflationary pressures in 1973, the Arab-Israeli war broke out, resulting in the 1973 oil crisis. By March 1974, the price of
oil had risen nearly 400%. 27 months later, in December 1976, the market returned to its 1972 peak. More recently, we have had the tech bubble with a peak in March 2000 and
a trough in September 2002, with a 45% peak to trough drop. Maybe less intimidating in terms of the associated uncertainty, but at the very least the hopes and dreams of temporarily wealthy
technology investors were shaken. The U.S. ended a recession in March 2001, which lasted a year. The recovery in the stock
market took four years from the September 2002 trough. The great financial crisis
started in October 2007, with the stock market reaching
a trough in February 2009, down over 50% from its peak. Loose lending and outright fraud in the subprime mortgage market had resulted in a
precarious housing bubble and a baking and liquidity crisis. The crisis nearly resulted in the collapse of the global financial system and all of the civil unrest
that could have come with that. And it did result in the collapse of large and historic U.S. institutions
like Lehman Brothers. Three years after the
trough in February 2012, the market was back to
its October 2007 peak. Alright, alright. But the U.S. has had
tremendous economic success. I know that. Maybe it isn't fair to
cherry pick their data to instill optimism in the stock market. What about the elephant
in the room, Japan. Today, Japan is a third
largest economy in the world. In the 1980s, Japan was
an economic powerhouse, and its stock market was
the largest in the world, making up 45% of the world's public equity market capitalization by the start of the 1990s. The USA made up 29% of the
global market at that time. The MSCI Japan index
delivered an annualized return of 22.4% from January 1970
through December 1989, nearly double the return
of the U.S. stock market over the same time period. Starting in early 1990, the
Japanese economy began to stall, and its stock market dropped
36% by the end of the year. But here's the interesting part, it never really came back to life. From January 1990 through December 2019, Japanese stocks have
delivered an annualized 0.6% return before inflation. At the time of the collapse,
Japan had low interest rates, high stock market and
real estate valuations and a heavy corporate debt load. If that rings a bell, it should. All of those characteristics could be used to describe developed
countries like Canada and the United States today. To combat their slowing economy
and falling asset prices, Japan used some of the
economic policy initiatives that we are seeing today,
like quantitative easing including the purchase of corporate bonds and extremely low policy interest rates. Comparing any situation
to 1989 Japan is scary. Japan had a market drop 30 years ago that it has not recovered from today. It's easy for the representativeness
heuristic to kick in, estimating the probability of an outcome based on the outcome of a similar event. If the developed world today
it looks like Japan in 1989, maybe this time really is
different like it was for Japan. When Kahneman and Tversky first described the representativeness
heuristic in their 1974 article, Judgment Under Uncertainty,
Heuristics and Biases, they explained that this
approach to the judgment of probability leads to serious errors, because similarity or representativeness is not influenced by several factors that should affect
judgments of probability. Put simply, assuming
that the Japanese outcome will be repeated based
on some similarities probably doesn't make sense, especially considering that stock market and economic forecasts are often wrong. I don't think that the Japan story is an argument against optimism, it is instead an argument
in favor of diversification. And I don't just mean
geographic diversification. Over the same period that
the Japanese stock market returned 0.6% per year, Japanese small cap value
stocks returned 5.13% per year, and Japanese market wide
value stocks returned 4.04% per year. I'm not saying that those
are impressive returns, but even over this period
where the Japanese market was flat for decades,
value stocks delivered an independent source of return. This outcome is consistent
with economic theory. The same thing happened
in the U.S. for the decade from March 2000 through February 2010. You lost money in the U.S. stock market as a whole for a decade,
while U.S. small cap value and market wide value stocks
delivered annualized returns of 7.94% and 4.56% respectively. You can't make this stuff up. Global capitalism has been a
triumph of human resilience, perseverance and dynamism. That doesn't mean that
things won't change, like Japan being the largest stock market in the world in 1989 or the
UK being the largest in 1899. Some markets will decline permanently or at least for extended periods of time, as well some industries and
lots of individual companies. That is not an argument
to get out of stocks when the market inevitably drops. Every bear market is different. Bear markets happen due to uncertainty and uncertainty is
understandably hard to process. Nobody can see where the
bottom of a bear market is. Historically, most bear markets have been followed by recoveries, rewarding those investors
who stuck to their strategy. It is true that some bear
markets have not recovered, but for a properly diversified investor, hanging on through periods of uncertainty has produced a reliably
positive long term outcome. Thanks for watching. I'm Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video, please share it with someone
who you think could benefit from the information. And don't forget, if you've run out of Common Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast wherever you get your podcasts (bright music)
