Investment fire drill

What to do when the next bear market arrives...

August has been a relatively volatile month for global equities.

Stock markets the world over sold off sharply during the first week or so, sparked by a disappointing US Jobs report (prompting speculation that the US economy was heading for a recession) and a rise in Japanese interest rates (resulting in a partial unwind of the so-called ‘carry trade’ and general de-risking).

However, the declines proved short-lived. Markets have since recovered and are trading back near all-time highs.

Investors will breathe a sigh of relief – the week-long sell-off was but a mere blip in what has been an extremely strong rally since the middle of last year. From end-June 2023 to end-August 2024, the MSCI World Equity index (a proxy for global stocks) is up around 18% in GBP terms.

Alas, this week’s blog is a reminder that it won’t always be so good – a bear market is coming!

That’s not some doomsday prediction – we have no idea when the next bear will rear its ugly head, nor just how bad a bear it will be. But a bear will return nonetheless – it’s a matter of when, not if.

The purpose of this week’s blog is not to spark fear. Rather, it is to remind investors that whilst bear markets feel horrendous at the time, such short, sharp, market corrections are part of the investment journey. They are to be expected, can be planned for, and in some cases, welcomed.

Call this an investment fire drill - what to do when the next bear arrives.

What is a bear market?

A bear market is defined as a stock market decline, from the most recent peak, of -20% or more.

The chart below depicts every bull and bear market (based on the MSCI World Equity Index – a proxy for global stocks), including their duration and magnitude, going back to 1970:

Disclaimer: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

As you can see…

• Over the last 54 years, there have been 12 bear markets, so roughly one every 4-5 years,
• On average, global stocks suffered a 32% fall, peak-to-trough,
• The average duration (time before markets troughed and started to recover) was 11 months,
• The biggest bear was seen in the Global Financial Crisis ‘GFC’ of 2007-08, which saw c. 60% wiped off global stocks over a period of 16 months.

It gets worse…

I predict the next bear market will be worse than any that have gone before it.

Not necessarily in terms of magnitude or duration, but in terms of emotion, i.e. how investors will feel during this period.

This was highlighted in a recent podcast by esteemed financial planner, Nick Lincoln. He made the valid point that during the GFC - the largest bear of the last 50-plus years - few people had smartphones and investment platforms were no way near as advanced or mainstream as they are today.

The point here is that we now absorb news flow 24 hours-a-day, and can also track the value of our investments, in real-time, with just a few clicks.

And ‘bad news sells’ of course, so when the next bear comes, we’ll be constantly reminded of this with reports of “billions wiped off shares”; “markets in meltdown”; “this time is different”, etc. – there’ll be nowhere to hide.

Part of the investment journey…

That all sounds pretty traumatic, but now for the ‘Vitamin C’: bear markets are part of the investment journey.

Despite numerous crises over the last half-century – spikes in inflation; a pandemic; a global banking crisis; wars in Ukraine and the Middle East, etc., in every instance, markets have recovered and gone on to make new highs.

This is depicted in the chart below, which shows the long-term performance of the same MSCI World equity index referenced previously.

Since the start of 1970, it has gained around 6981% in GBP terms, equivalent to c. 8.1% a year.

As you can see, each bear market was followed by a bull market (defined as a 20% rise in the value of stocks), typically of a greater magnitude and longer duration than the preceding bear.

The above is a testament to human ingenuity – our ability to create incredible innovations that have driven continued economic growth – think of the way we communicate, travel, work, etc. and how different these are to ten years ago, let alone fifty.

There will be ‘bumps in the road’ but there is no reason to believe this long-term trajectory will change.

Bear market planning

How should we prepare for the next bear market?

By doing very little…

We’d love to know when the next major market descent or ascent is coming, but history tells us that these things are extremely unpredictable. The key is to ‘keep your shirt’ when the next bear comes, i.e. to stay invested for the course.

Furthermore, bear markets present opportunities. And the extent to which you can capitalise on these depends on where you are in your ‘investment journey’:

• Those in ‘accumulation’ (i.e. adding to their investments) should welcome the next bear market as this will enable them to purchase equities at temporarily depressed prices, culminating in strong gains when markets subsequently recover,
• Those in ‘decumulation’ (drawing on their investments) are more exposed but we can partially hedge this by tapping cash for a period (to let investments recover), whilst also benefiting from rebalancing on any investment portfolios – switching out of those assets that have outperformed and into those that have underperformed, providing an automatic ‘buy low, sell high’ mechanism.

The other point to make is that most of our clients won’t be fully invested in equities, certainly those in ‘decumulation’. They will also hold some bonds and cash, which should provide at least some protection against any stock market declines in the next bear market.

This is well illustrated in the table below, taken from the ‘Matrix Book’ of Dimensional Fund Advisors (investment managers).

It shows performance since inception, along with the best and worst 1- and 3-year returns, for different equity-bond allocations (from 100% bonds to 100% equities, in increments of 20%):

Focussing on the 80/20 portfolio for example (highlighted above; implies an 80% equity allocation, 20% bond), its worst 1-year return was -25.8% between October 1989 and September 1990, and its worst 3-year return was -6.7% pa (-18.9% cumulative) in the aftermath of the dot-com boom.

However, since its inception in 1985, it has returned an annualised 10.0% a year, including a surge of 54.9% in its single best year from September 1992 to August 1993.

We’ve seen these moves before, we’ll see them again. But as Warren Buffett once said, “The stock market is a device for transferring money from the impatient to the patient.”

Conclusion

Stock markets don’t go up in a straight line.

On average, we expect a c. 10-15% fall in the value of global equities every year (we’re due one) and a 30-40% drop and full recovery every 4-5 years (the last one was in 2020).

However, the key points about downturns are:

• They have always been temporary,
• Recoveries have always been full,
• The longer-term uptrend has always reasserted itself, driven by human ingenuity,
• Bear markets present opportunities through the ability to buy into the greatest companies of the world at temporarily depressed prices,
• And for those in ‘decumulation’, allocations to cash and bonds enable us to ‘protect’ equity holdings for the subsequent rebound.

There will be another bear market. It will feel horrendous. But it’s a perfectly, natural, normal thing and we’ll be on hand to guide our clients through it.

Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.