Monthly Investment Commentary | March 2008

Stocks continued their slide in February, with the S&P 500 (as measured by Vanguard 500 Index Fund) losing 3.3%, bringing its year-to-date loss to just over 9%. Performance was bad in most areas of the market; growth lost less than value in February, but still trails value on the year. REITs, which held up well in January, resumed their decline that began last spring. Losses for REITs were roughly in line with the overall stock market in February. Foreign stocks eked out a small gain, as did domestic high-quality intermediate-term bonds. Foreign bonds, including short-term local-currency emerging-markets bonds, did well, with gains of around 2% for the month. The Dow Jones AIG Commodity Index soared by 12.3%, bringing its gain through the first two months to a whopping 17%.

Given the sharp run up in commodity futures and their volatile nature, for those who follow our models, we recommend rebalancing your commodity futures positions back down to the 3% target weight if they have climbed higher than 3.6% (or 20% beyond the target).

When we address fixed-income performance in our recaps, we mostly focus on taxable bonds. But municipal bonds have been relatively hard hit (relative to their credit quality) in recent months, and the trend has worsened recently.

One final note: we are in the process of reviewing TCW Select Equities following the departure of co-manager Steve Burlingame. We expect to report our conclusion in the next one to two months.

Dissecting Market Downturns

Stocks dropped more than 15% from their highs of last October through mid-January, and as valuations have gotten more attractive, we have focused on identifying the point at which we would tactically overweight equities. For now we believe equities are in a fair-value range, and remain at our neutral weightings for stocks. But even as we think about adding to our equity positions, it’s worth pointing out that when the market drops by this magnitude, we share the concern of many investors as to how far prices may drop and how long the pain can last. A key point is that (all else equal) market declines increase the return potential that exists from that point forward, but they also increase the perception of risk and the temptation to throw in the towel after much of the damage has been done. Amid the current challenging environment, we decided to look to history for context about how market declines play out, and more specifically how various levels of market decline may impact the potential investment results going forward.

We want to emphasize that even after sorting through data and calculating averages and medians, we do not expect to discover statistical rules-of-thumb or predictive factors that provide a perfect reading on today’s market. Context, after all, is everything. Basing investment decisions on quantitative rules doesn’t allow for the fact that history never repeats itself exactly, and today’s investment environment is driven by its own unique underlying conditions. We gathered data on historical market downturns in order to look for patterns or trends that might help us understand why the market has a more extreme reaction in some situations than others.

With the help of Ned Davis Research, we began by identifying losses of 15% or more in the S&P Composite (and its successor, the S&P 500) since 1950. We did not include this year’s downturn since we are still in the midst of it. The average length of the 12 market declines we examined was about one year. The average loss (peak to trough) was 28.5% and the median loss was 24.6%. In contrast, the average gain in the 13 intermittent periods was 112%. (The median gain is noticeably smaller at 74%.) These periods lasted about 3½ years on average (or 2½ years using a median measure).

Our starting point begs at least two questions: why set the bar at 15% and why just look at the period since 1950 when data going back further in time is available? We chose the post-1950 period because we feel that data from the first half of the 20th century was less relevant to present market conditions, given the level of change in the economy and how it is managed. (As just one example, there are important sectors such as technology that didn’t exist prior to World War II.) As for why we initially chose to identify periods with losses of 15% or higher, the simple answer is that this is the level of decline we had reached when we started the work last month. We also wanted to have a realistic framework for setting expectations. While a 10% loss is certainly not fun, there have been numerous market corrections between 10% and 15% that quickly reversed, and including them in our data-set ran the risk of minimizing the potential severity of market losses and expected recovery times.

That brings us to our first interesting discovery. Whereas market declines of 10% often reverse themselves, there were not many periods where the market decline reached 15% and didn’t subsequently go on to reach “official” bear market status of a 20% or greater decline. In one instance, the S&P 500 dropped 17.1% in the winter of 1980 and regained its high by the summer. In 1976 to 1978, 1990, and 1998 the market dropped 19.4%, 19.9%, and 19.3%, respectively. We included these three periods together with 1980’s 17% drop in our analysis. The other eight periods we examined experienced declines above 20%.

Duration of the Downturns

You’ve probably heard it many times before, but it’s a reassuring fact to repeat: bear markets over the last six decades have generally not lasted as long as bull markets. As mentioned earlier, the average length of the downturns we looked at (one year) was less than a third of the average duration (3½ years) of the intermittent rising markets (most could safely be called “bull markets” but some are less clear). If we assume the bull market that began in October 2002 peaked this past October, then the most recent bull market lasted an above-average five years. More importantly, over the last 58 years, the S&P 500 has spent more time going up than down. Based on the 12 time periods shown in our table, the market has spent about 12 of the last 58 years declining, while it has generally risen over 46 years. That has made all the difference to investors’ bottom line—at least to those investors who have remained in the stock market for the long term.

The 12 periods we examined differed markedly in a number of ways. On average, a 15% loss in the S&P occurred over six months. But some periods sustained a 15% drop very quickly (within one or two months) and others (notably the bear market decline that began in March 2000) took longer. There also did not appear to be any relationship between the time it took to reach a 15% loss and the ultimate depth of the trough. However, with a few exceptions, if the market dropped 15% quickly, it also reached its ultimate, deeper trough quickly (regardless of the size of that trough). If it dropped 15% at a more languorous pace, it also took its time as losses continued past the 15% mark. Where does this leave us? Based on the limited data we have, the 15% drop in the S&P 500 in the three months through mid-January 2008 occurred more quickly than most previous 15% declines. So if equities resume their downward march, it’s certainly possible that the market will trough quickly and the worst will be behind us sooner rather than later. But we lack a sound basis by which to judge how deep or intense the pain will be.

Bear Markets, Bull Markets, and the Economy

We also looked for a relationship between the severity of a market downturn and the level of gains in the preceding period or the occurrence of a recession. In both cases, no clear correlation was evident. In the 12 rising and subsequently falling periods we examined, only two periods (1982 to 1987 and 1998 to 2002) had above-average gains followed by above-average losses. When we looked at past recessions, seven of the nine recessions that have occurred since 1950 overlapped market downturns. Confirming the market’s forward-looking nature, stock prices began climbing again in six of these periods before the recession actually came to end. But the question as to whether or not we are currently in a recession may be moot when it comes to setting expectations. In five of the 12 market declines we looked at, investors sustained losses above 15% but no recession occurred at all. This includes late 1987 when the market dropped 33.5% within four months. The average loss in the seven bear markets that overlapped a recessionary period was 31% versus 24.5% during bear markets where no recession occurred. However, the seven bear markets that overlapped with recessions were also longer in duration, lasting over 15 months on average compared to about half that duration for downturns in the midst of healthier economic times.

Recovery and Subsequent Returns

As long-term investors, we know that patience is required to ride out market downturns, but we were curious as to how long it takes for that patience to be rewarded in the “recovery” phase following a market decline. On average, in the 12 bear markets we looked at, investors recovered their losses over a period of about 14 months. That average factors in the recovery times from two severe market declines in the mid-1970s and early 2000. The median recovery time is quite a bit less at eight months. In nine instances, recovery from the market trough was accomplished in a year or less.

We calculated the recovery period for these downturns using both the S&P 500 Total Return index and the S&P 500 Price index. In doing so, the role that dividends play also became clear. Dividends allowed investors to recoup losses from market downturns almost five months sooner on average.

Of course, our expectation is that equities don’t just recover their losses—they also reward investors with significant gains. With that in mind, we looked at annualized total return performance for the S&P 500 in the years immediately following downturns of 15%. The good news is that among the 12 declining periods we examined, the bear market that began in March 2000 was the only market downturn producing a negative three-year total return following the point at which a 15% loss was reached. Even in the 1973 to 1974 period, when the market fell 48% over almost two years, investors eked out a 4.6% annualized return in the three years after they sustained a 15% loss. The bad news is that in the five years following a 15% loss, the positive returns were only single-digit returns in half of the periods we examined. However, the big picture reinforced our view that patience through market downturns will ultimately reward investors. On average, the market returned 9.8% annually in the five years following the point at which a 15% loss was reached—slightly lower than the historical long-term return on stocks.

Conclusion

In summary, our analysis allowed us to make the following observations:

• In general, the market has spent more time going up than going down. The most recent bull market lasted longer than average.
• The 15% loss sustained between last October and mid-January occurred faster than average. In other downturns, the market often reached a trough quickly if it dropped 15% quickly. If this downturn is similar, the worst will be behind us sooner rather than later. But the depth of the trough is a big unknown.
• The question as to whether or not we are currently in a recession is, to some extent, moot. Significant downturns have occurred in non-recessionary periods. However, downturns that have overlapped recessionary periods have been more prolonged so this is a risk we need to be cognizant of.
• We continue to believe that a long-term investment in equities will be rewarded. If history is any predictor, it’s very likely that returns over the next five years will be positive. However, there’s also a reasonable chance they will be mid-single-digit returns.

That’s where the statistics leave us. But as we noted earlier, context is everything. Only two of the 12 downturns we looked at were particularly prolonged and severe, but many commentators today draw parallels to the 1973 downturn, when a host of political and economic conditions dragged the U.S. into malaise. The 1973 to 1974 period included the Watergate scandal, the Vietnam War, the Arab oil embargo, stagflation, and the resignation of both Vice President Spiro Agnew and President Richard Nixon. Notably, the 1973 to 1974 bear market occurred in the midst of the longer-term secular bear market that stretched from the early 1960s to 1982. During this period, nominal prices on the index rose but due to high inflation, investors did not earn positive real returns on stocks for approximately 20 years. During the 1973 to 1974 stock market decline, the Fed reacted to inflation by repeatedly raising the Fed Funds target rate from 5.75% in January 1973 to a high of 13% in the summer of 1974.

Today’s similarities are obvious: the U.S. military is in Iraq, oil prices have soared, inflation has been climbing (it recently reached a 4.3% annual rate), and if we are not currently in a recession, we are nearer to one every day. But the reaction of the Fed under Ben Bernanke provides the biggest contrast to the 1970s. In fact, one could argue that the current environment bears closer resemblance to the 1990 bear market when the S&P dropped 20% and the Fed lowered rates. That decline was preceded by a bull market fueled by hostile takeovers and leveraged buyouts (consider the recent private-equity boom). On the fixed-income side, yield-chasing investors purchased junk bonds (consider the popularity of securities backed by subprime mortgages). The U.S. entered recession in July 1990 and Iraq invaded Kuwait in August. As stock prices declined, some large financial stocks lost 70% to 80% of their value and inflation spiked from 4.8% to 6.3%.

We don’t possess a crystal ball, but if we did, the rate of future inflation would be among the first items we would check. Inflation persisted throughout the 1973 to 1974 market downturn and its reoccurrence in the latter half of the decade helped to eliminate real stock market returns for investors (even as the economy expanded and the market made nominal gains.) In the 1987 market drop, stocks dropped 33% and inflation rose. However, the Fed’s ability to keep inflation in check in the subsequent period resulted in positive real returns for investors. As a result, while our examination of previous market declines reinforces our belief that stocks can reward patient long-term investors, we are also aware that periods of rising inflation (or, of course, deflation, as in Japan in the 1990s) carry their own risks. That, in the end, is why we continually assess the downside risk to our portfolios under a variety of possible scenarios, not just during market downturns, while maintaining our longer-term focus on maximizing returns.

— Stapp Financial Planning, PLLC

This information is also available at www.stappfinancial.com, or you can download a PDF version. To contact us about the newsletter, send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances.