Horror must be the equivalent film genre for equity bear markets. Take any classic in that category and the mood inevitably shifts from relatively relaxed to panic-stricken, often in abrupt fashion. Few would deny that equity bear markets tend to follow this simple sequence. Sure, there may be a small cohort of investors that credibly claim they predicted the downturn in advance, but those investors’ outlook is not the market’s consensus view. More importantly, the decisions an investor—or a horror film’s protagonist—makes during difficult times can have an outsized impact on how he or she fares.

We believe the best way to navigate an equity market downturn is to enter it with a plan in place. For many investors, the plan may simply be to rely on a well-constructed asset allocation policy and to stick to their pre-determined rebalancing policy. Investors would be well served to periodically review their asset allocation policy to ensure it aligns well with the asset owner’s risk tolerance and serves his or her financial objectives. While the next downturn will no doubt vary from prior ones in ways we will not expect, a plan can help to prevent rash decisions.

This piece focuses on a key input into any plan—market history. We examine data from prior equity market downturns to understand how different asset classes have tended to perform. We also review how difficult it is to identify a market bottom during a downturn, highlighting the abysmal economic data that are common at bottoms and the limited utility of valuation data as a timing tool. Finally, we illustrate how cutting the size of a target equity allocation or holding a below-target weight allocation may undercut a portfolio’s performance. Ultimately, equity market downturns are chaotic environments that are rarely short-lived—the best advice is to be prepared.

Descent into Chaos

So, what do equity market downturns look like, and how do other asset markets perform in such environments? We examined periods over the last 50 years when the month-end price level of a prominent US equity benchmark declined by at least 20%. We chose to review the US equity market, given its large allocation in equity portfolios and its considerable influence on non-US equity markets. By our measurement, there have been five equity market downturns—also referred to as bear markets—during that time period, with one occurring roughly every decade.^[1]Please see our methodology note at the end of this piece.

Unsurprisingly, the data paint a bleak picture. The worst downturn across our study period overlapped with the global financial crisis (GFC), when US equities returned a heart-halting -50.9%.^[2]Please see the appendix for three analyses of global asset class performance during equity drawdowns as determined by an equity price level of developed markets, the UK market, and the Euro Area … Continue reading Sadly, the median return across the five bear markets (-42.6%) is not much better. High levels of volatility were common to these periods—the annualized standard deviation of monthly US equity returns across all downturns was 17.7,% as compared to 13.6% in all other environments. And, unfortunately, the difficult return environment was rarely swift. Instead, investors had to rationalize their investment choices for a lengthy one to two years during most downturns.

Other equity markets displayed similar returns during downturns as US equities. The median USD total return for developed equity markets excluding the United States was -28.8%, which is a challenging result even if it is more than 10 percentage points better than the same measurement for US equities during the same period. But, in looking at just the last two downturns, which allows us to review emerging markets equity performance as well, we see all equity returns were quite similar. Given how interconnected global markets have become, it is reasonable to consider the equity market behavior witnessed more recently as the most applicable to future scenarios, all else equal.

Yet, not all asset classes performed poorly. The median returns for cash and US Treasuries during the five equity bear markets were 8.1% and 13.3%, respectively. Those investments no doubt benefited from investor desires for both quality and liquidity. While the median gold return (16.8%) was higher than US Treasuries’, the investment was more volatile, with gold’s return deeply negative during one of the five periods. Similarly, commodity futures and the dollar had mixed results across the different time periods, but both exhibit negative median returns.

Perhaps surprisingly, US equity market downturns and economic recessions do not always overlap. In fact, bear markets coincided with just four of the six US recessions across our study period (the 1973–75, 1981–82, 2001, and 2007–09 recessions), with bear markets typically leading recessions by roughly seven months. The equity market contractions experienced during the two other US recessions (the 1980 and 1990–91 recessions) were less severe, and the 1987 crash occurred as real GDP growth was positive and accelerating.

An Ambiguous Bottom

Consider the following economic environment—real US GDP, industrial production, and retail sales are contracting rapidly; financial conditions are exceptionally tight; and price levels are teetering on the edge of deflation. As you might have guessed, that environment was not fictional. It reflected economic data known in early 2009 when equity markets hit a bottom during the GFC. To perfectly time equity markets during that downturn, an investor would have needed the resolve to rebalance into that dire economic backdrop. Obviously, that’s no easy task!

The challenge with identifying equity market bottoms is the lack of an obvious timing signal. For instance, while the popular cyclically adjusted price-earnings (CAPE) ratio contracted across all five equity market downturns, the magnitude of the decline varied widely from -26.1% to -53.2%. Moreover, the multiples at the various market bottoms also differed, ranging from 8.4 to 24.0. In fact, only two of the five multiples at market bottoms were even in the bottom quartile of historical observations. This is not to say that valuation data are not helpful; rather, they are ineffective timing tools.

False equity market bottoms also make it difficult to identify a true bottom. Two of the five downturns we reviewed (2000–02 and 2007–09 downturns) contained so-called “relief rallies” when equity markets pared back some of their losses. Both rallies were considerable, returning more than 20% to investors using daily data, and it would have been easy to confuse them with an end to the downturn, as many common momentum signals turned positive. But these rallies were eventually overtaken by the challenges that originally prompted the downturn, and equity prices eventually fell to lower lows.

Not only is timing a market bottom a challenging endeavor, but poor decision making during a downturn could undercut a portfolio’s performance to a greater degree than in other environments. This stems from the market’s tendency to mean revert from extreme positions, which in this case means that abnormal performance in one direction is often followed by abnormal performance in the other. Take, for instance, our five equity market drawdowns—the one-year US equity return following market bottoms ranged from 23.2% to 59.0%, with a median of 38.0%. Investors that cut the size of their target equity allocation or that hold a below-target equity weight would have pocketed a smaller share of those rare chunky returns.

Lessons Learned

Equity market downturns are difficult environments to navigate. To maximize the probability of navigating one successfully, investors should have a well-constructed asset allocation policy in place that is meant to withstand the ups and downs of market cycles. This policy should be regularly reviewed to ensure its associated risks continue to align well with the asset owner’s risk tolerance. Investors should also devise a plan for responding to an equity market downturn and share it with other investment decision-making stakeholders. For many investors, the plan may be to rely on their asset allocation policy and follow their pre-determined rebalancing policy.

While a plan to manage a portfolio through an equity market downturn should be devised with an investor’s specific circumstances in mind, it should also be informed by market history. Specifically, downturns can be prolonged affairs with considerable bouts of volatility, and market bottoms have not been easy to identify. A plan should also be informed by an in-depth understanding of liquidity, diversification, behavioral biases, and what assets might perform well as a rebound occurs, all of which are explored in the companion pieces of this series. An investor with a plan rooted in these areas stands the best chance of being prepared for the next equity market downturn. ■

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Kevin Rosenbaum, Deputy Head of Capital Markets Research

Stuart Brown and Graham Landrith also contributed.