David Leduc (DL), head of fixed income at Mellon, and George Saffaye (GS), global investment strategist at Mellon, dissect five past bear markets (20% peak-to-trough) and reveal what they think the biggest takeaways were for investors.
1. The Global Financial Crisis
In many ways the world is still recovering from the impact of the 2008 global financial crisis and the policy decisions resulting from it. The biggest crisis since the Great Depression, its roots lay in a US debt-fueled home purchase binge, which led to a spike in house prices.
At the same time, US lenders relaxed their lending standards, approving mortgages without requiring proof of assets or income. A critical flaw in the thinking behind these loans – and the complex securities1 related to them – was the assumption that house prices would not fall.
The financial system started to crumble under the weight of these low-quality loans and many flagship financial services companies went bankrupt, or were sold at distressed prices. The bear market that resulted lasted 17 months, with the S&P 500 Index losing more than half its value in dollar terms.
Extraordinary monetary policies were adopted by the US Federal Reserve (Fed) and other central banks to save the financial system. This set a precedent for the aggressive policy actions taken during the European debt crisis and the current crisis.
Unfortunately, there is no warning as to when a bubble will burst. Investors can only try to understand when markets appear extended, question all assumptions underpinning market conditions, and adjust for risk appropriately.
DL: “This bear market highlighted the danger of misusing a financial innovation. A notable feature was the use of extraordinary monetary policy by the Fed and other central banks to save the financial system. This set a precedent for the aggressive policy actions taken during the European debt crisis and this most recent crisis.”
GS: “A critical flaw in most financial models that underpinned mortgages, and the exotic securities related to them, was the assumption that housing prices would not fall. Sadly, there is no warning as to when a bubble will burst nor a way to systematically avoid them. Investors can only try to understand when markets appear extended, push on all market and economic assumptions underpinning current market conditions, and adjust for risk appropriately.”
2. The Dot-Com Crash
Exuberant investment in technology companies, often with scant regard to the solidity of their business models, led to a tech bubble in the late 1990s. An unpreceded number of private companies offered shares to investors to raise capital during 1999 and 2000, and the market became increasingly speculative.
Companies found raising capital easy with accommodating capital markets, which led to surging stock prices. This was also the era of some major financial accounting scandals, notably World Com and Enron.
The market was already struggling to shake off the excess from prior years when the 11 September 2001 terrorist attacks occurred. This helped push the economy into a recession—a 30-month bear market, during which the S&P 500 Index lost just under half its value.
The signs, however, had been there for those who cared to look for them. Stock prices were rising way ahead of earnings, and many companies had dubious business models. By sticking to fundamentals, modeling a company’s business growth, understanding its product set, intellectual property or business model investors can properly assess a company’s prospect for growth.
DL: “The dot-com crash was the result of many years of exuberant investment in technology companies—many with questionable business models. This was also the era of some major financial accounting scandals, notably World Com and Enron.”
GS: “It’s very unlikely stocks can grow high double-digits into perpetuity. Stock price appreciation was way ahead of earnings, and many of these companies had questionable business models, jeopardizing the delivery of those earnings, even into the future. Sticking to fundamentals, modeling a company’s business growth, understanding its product set, IP or business model are examples of how to properly measure a company’s growth sustainability.”
3. The Gulf War
The US economy had already been weak as a result of tighter monetary policy2 when the Gulf War began in August 1990, leading to an accelerating decline in stocks.
The war caused oil prices to spike to their highest levels in a decade and a recession followed in the US. The downturn, however, ended up almost as short-lived as the war itself, with the market bottoming in October 1990 and making new highs by February 1991.
Conflicts and other unpredictable and disruptive global events will always be part of the investment landscape. Skittishness during increased market volatility can lead to questionable decisions. Investors should remain focused and look past short-term noise for long-term opportunities.
DL: “During this time, Executive Life Insurance Company, the largest of its kind in California, failed as a result of many years investing in ‘junk bonds’. The use of ‘junk bonds’ or high yield bonds to finance corporate investments and leveraged buyouts is an example of overuse of a financial innovation which ultimately created systemic risks.”
GS: “Despite continuing conflicts that contribute to an uncertain future, I believe we must persevere through it and remain focused. This will always be a part of the investment landscape. Skittishness during increased market volatility can lead to questionable decisions. I think investors should remain focused and look past short-term noise for long-term opportunities.”
4. Black Monday
The 1987 bear market was one of the first to highlight the potential impact of computer models used to guide hedging3 and trading strategies. There is continuing debate about whether these quantitative strategies, known as ‘portfolio insurance’, both contributed to the rise in valuations and exacerbated volatility.
An already volatile market was further rattled when Iran fired missiles at oil tankers and the US responded by destroying Iranian oil platforms. This ultimately sparked the ‘Black Monday’ market crash of 19 October 1987 when the S&P 500 Index declined by more than 20% in a single day.
The bottom of this bear market came just six and a half weeks after it began and the recovery was swift and stable. Those who sold in panic and left the market missed out on a significant rally later on compared to those who invested or rebalanced towards equities4 and boosted their returns. It serves as another reminder of the need for investors to keep a steady head during inevitable periods of geopolitical turbulence.
DL: “This was the first market crash where the use of computer models, to guide hedging and trading strategies, was singled out as a potential cause or accelerant. There was a continuing debate about whether these quantitative strategies known as ‘portfolio insurance’ both contributed to the run up in valuations and exacerbated the volatility.”
GS: “We live in a world fraught with risk and conflict, something that is ever-present. This will always be a part of the investment landscape. In this bear market, we hit bottom approximately six and a half weeks after it began and the recovery was swift and stable. Those who exited the markets and then capitulated missed a significant rally versus those who invested or rebalanced towards equities and boosted their returns during the rally.”
5. Extreme Monetary Policy
After a decade of sustained inflation, in early 1980 the Fed raised interest rates to nearly 20%, pushing the US economy into a recession.
Inflation, which had been elevated ever since the 1973 oil shock, had risen to an astounding 13.5% by 1980. The Fed increased interest rates aggressively over the course of six months, with the Fed funds rate eventually reaching 17.6% in April of that year. The market finally bottomed in August 1982 after steadily declining for approximately two years. But by November 1982, just three months after bottoming, the market reached new highs.
DL: “One lesson from this environment is the economic cost of persistent high inflation. The stimulus package being instituted during the current crisis may remain in place long after the medical crisis has past, raising the risk of a high inflation environment in the future.”
GS: “The quick recovery demonstrated that economic challenges do not necessarily require government stimulus or low interest rates to aid recovery. Actually, the response that worked well during this time period involved raising interest rates, lowering taxes, and removing regulation. The lesson learned is that even when the economy is in the throes of double-digit inflation and unemployment, staying invested can be better than not.”
6. And what now?
So much for five previous bear markets. Today, with the spread of Covid-19, we face equal or greater challenges. Stock markets have already seen the biggest selloff in a generation. Even gold – that ultimate ‘go-to’ asset for investors in troubled times – suffered in the face of a dramatic ‘dash for cash’ over recent weeks.
Since then central banks and policymakers have stepped in with a coordinated and unprecedented response. Among many actions they have taken is the lowering of interest rates – in some cases to levels never seen before. And, for now, volatility appears to have calmed slightly. But, as Covid-19 continues to spread around the world – and as the resulting economic lockdown gathers pace – where we go from here remains an open question.
One thing previous bear markets have taught us, however, is that life goes on. In each of these five bear markets, sell-off was ultimately followed by recovery. As ever, a small dose of historical context goes a long way to informing our current predicament.
1. Security: a tradable financial asset such as a share in a company or a fixed income security also known as a bond.
2. Monetary policy: a central bank’s regulation of money in circulation and interest rates.
3. Hedging: a method of reducing unnecessary or unintended risk.
4. Equities: shares issued by a company, representing an ownership interest.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.
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