Bear Markets & the Contrarian Payoff
Analysis of historical bear markets and returns after moments of fear
The stock market is known to be cyclical and volatile.
The table below shows the annual returns of the S&P 500 over the last 20 years.
Looking at the historical data, it should be no surprise that equity markets eventually correct.
While drawdowns may be uncomfortable, they should not be unexpected.
Frequency of Market Declines
A correction is generally defined as a decline of between 10% and 20% from the most recent high.
A bear market is generally defined as a decline of greater than 20% from the most recent high.
Morgan Housel shared research regarding the frequency of stock market drawdowns.
A roadmap for opportunity, Morgan Housel
Investors should expect a decline of 20%+ at least every 4 years.
Given this historical context, the market seems to be particularly volatile recently.
Including the drawdown in 2022, there have now been three bear markets in the last four years.
2018: -19.8%
2020: -33.9%
2022: -23.5% (ongoing)
Average Bear Market
Every drawdown is unique, caused by a variety of factors that are specific to the particular situation. That being said, analyzing a collection of instances can help inventors draw insights or patterns.
The table below shares a summary of bear markets in the S&P 500 going back to the 1950s.
How To Invest In A Bear Market | Seeking Alpha
The average decline in a bear market is 30.2%.
The average decline lasted for 338 days, or just under a year.
The average recovery took 603 days, or just over 1.5 years.
There are a few outliers that took over 4 years to recover, with two of those occurring relatively recently in 2000 and 2007.
As for the 2022 decline, the market is down 23.5% over 164 days, from the peak in 1/3/2022 to 6/16/2022.
If the current bear market were average, the bottom would form toward the end of 2022.
By July 2023, we would be back to the previous high.
While history can be useful for framing possibilities, it should certainly not be considered conclusive.
Payoff for Being Contrarian
“Be fearful when others are greedy, and greedy when others are fearful.”
- Warren Buffet
Corrections and bear markets may be uncomfortable, even painful, while they are ongoing.
In hindsight, the significance of the opportunity becomes apparent. Every correction, bear market, and recession has been followed by economic expansion, and eventually, a new all-time high.
VIX index
One way to measure fear is via volatility. Because prices tend to drop faster than they rise, volatility can serve as a proxy of fear.
The VIX seeks to capture volatility.
“The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.”
- VIX Index, CBOE
Returns after elevated VIX levels
Adrian Tout published his findings regarding S&P returns following elevated VIX readings.
The following tables show market returns after the VIX moves above 35 and 45 respectively
When the VIX reached 35, the median returns were
14.9% over the ensuing 1 year
25.9% over the ensuing 2 years, or 12.2% per year
34.2% over the ensuing 3 years, or 10.3% per year
When the VIX reached 45, the median returns were
18.7% over the ensuing 1 year
30.9% over the ensuing 2 years, or 14.4% per year
46.8% over the ensuing 3 years, or 13.6% per year
As for 2022, the VIX surpassed 36 in March 2022.
Closing
“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
– Benjamin Graham
Investing is full of psychological pitfalls. Investors are best served by being keenly aware of them and closely monitoring their behaviors. In times of significant change, such as drawdowns, investor emotions tend to overrule rational judgment.
Warren Buffet, recognized as one of the best investors of all time, is known for building up cash during the good times and deploying it during difficult times. This is easier said than done.
Reflecting on the recent drawdowns, Buffet told the story of being too early in buying in the 2008 financial crisis.
In 2020, Buffett acknowledged that he missed the opportunity, waiting for things to get cheaper before dipping in.
In 2022, he has been actively deploying capital.
Mastering these types of behaviors, such as conviction, courage, and patience, is an important skill for an investor to be successful. It may be difficult to learn from theory alone and likely requires practical experience.
Bear markets can cause significant angst while they are ongoing. In retrospect, they are easily recognized as valuable opportunities. In investing, fortune favors the patient.
--
Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
Disclaimer: This post and the information presented are intended for informational purposes only. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.