Downturns and Recoveries

This edition of Equitas’ KnowRisk series is focused on the history of stock market downturns, as well as the recovery periods that have followed. Clearly, every investor will read this information with an eye toward the precipitous declines that the markets experienced in the fall of 2008. For many investors, events like these can be hard to weather-and certainly there are many who have thrown up their hands in frustration in recent months. However, history teaches us that over the long term, markets tend not only to recover from even the most severe downturns, but to generate stronger returns over a long-term time horizon than any other investment.

Even though this history can be reassuring, it is important during periods of negative market performance to understand the effects, both long- and short-term, that downturns and recoveries have had on investments in the past. With that in mind, we turn to an exploration of market performance over the last few decades, leading up to the current turmoil.

MARKET CYCLES SINCE 1973

As we are in the midst of a downturn that will (hopefully) soon lead to a recovery, it’s too early to draw any insight from the current market situation-history is still being written in each day’s market results. For that reason, the graph below is limited to a discussion of the seven market downturns that occurred during the past 34 years, ending with the peak of the last market expansion.

The areas shaded in red highlight the periods during which the stock market contracted, while the blue regions indicate the market’s expansion phases. For purposes of this graph, a “contraction” is defined as a time period during which the market declined from its peak by 10% or more, while an “expansion” refers to the period between the bottom of one contraction and the subsequent increase in market value up to the top of the next peak.

Downturns and Recoveries

As you can see, the red, declining periods seem to occur at random, and their durations also vary widely. Certainly, none of these periods were pleasant ones for investors, and surely in the midst of the more protracted declines it seemed as if the bad times would never end. While it is too early to say when the current bear market may end, history shows us that there tends to be a significant opportunity for strong returns at the end of each down cycle.

Clearly, in spite of periodic setbacks, the market has grown over time. To take one example, the stock market fell from its peak at month-end May 1990 to its trough in October 1990 by-14.7%, but grew by 354.8% by the time it reached its next peak in June, 1998. And while no one can predict the timing or severity of market declines with precision, investors who have clear, long-term-oriented goals, and who are not swayed by short-term trends have tended to be better off than those who focus on short-term gains or declines.

MARKET DOWNTURNS AND RECOVERIES: 1926-2006

Here, we take a closer look at the severity and length of each major decline since 1926, as well as the amount of time required for the markets to reach their previous peaks. By studying this chart, we can see why even relatively brief downturns can have a significant short-term (and even medium-term) impact on investments, in spite of the markets’ tendency to generate strong returns over the long term. For each of events in the chart, the red area indicates the length of the downturn period, while the blue area indicates the amount of time that elapsed before the markets again reached their pre-decline peak. For example, in the downturn that occurred in 1977-1978, the markets declined by 14.1% over the course of 14 months; however, once the recovery started, the market reached its previous highs after only five months of positive returns.

While many of the downturns and recoveries illustrated here are relatively brief, there are two notable exceptions: the 1929 crash that inaugurated the Great Depression saw stocks lose more than 80% of their value-while the initial downturn lasted nearly 34 months, the markets didn’t see their previous peak again for more than 12 years. More recently, the market lost 44.7% of its value during the early 2000 bear market, and took just over 4 years to recover, which marked the second-longest recovery period in stock market history.

Here again, we can see the unpredictability of downturns, both in terms of length and severity-these events can be sudden, and are sometimes severe. Moreover, it is difficult to know how long the market will take to recover from each shock. The reasons for each downturn vary, though many are preceded by a period of high values that may lull many investors into a false sense of security. When suddenly faced with sharply negative returns, some of these recently complacent investors can behave irrationally if they are not focused on their long-term goals. In the face of uncertainty, the best solution for a long-term investor who is concerned about both returns and risk is a diversified portfolio.

PERIODS OF CONSECUTIVE NEGATIVE STOCK RETURNS: 1926-2007

Over the past eight decades, there have been only four periods during which the market has experienced negative returns for two or more consecutive years. While it is somewhat reassuring to note that consecutive years of negative returns are rare, the more important message here is that each of these periods has been followed by a year of above-average positive returns.

Investors who succumbed to the pain of multi-year losses in each of these occasions by deviating from their investment plans or liquidating their holdings would have missed the opportunity to enjoy the outsized positive returns generated during the first year of recovery. The lesson, then, is clear: while staying true to a long-term investment strategy during periods of negative growth can be difficult, pulling out of a down market guarantees not only that any losses will be permanent, but that a portfolio will not participate in any subsequent opportunities for recovery.

Clearly, maintaining a disciplined investment approach is a vital part of any strategy for handling market declines. In addition to maintaining a well-diversified portfolio, disciplined investing habits can include techniques like dollar cost averaging, a technique by which investors purchase a predetermined number of shares of a given stock at regular intervals, rather than making a lump-sum purchase. By easing into new investments in this way investors can lower their cost basis (by purchasing more of a stock when it is down, and then less and less as its price improves); the technique also helps to remove some of the psychological barriers that can affect lump sum investing. By maintaining discipline in both portfolio balancing and entering new positions, investors maximize their opportunity to participate in any eventual recovery.


TRYING TO TIME THE MARKET

When investors withdraw money from the markets, and then re-invest it at a time when they feel more comfortable with market trends, they are attempting to time the market. We discussed the risks of market timing in an earlier edition ofK.nowRisk6, but a series of studies by Dalbar, Inc. provides a particularly compelling example of how market timing can negatively impact an investor’s earnings over the long term.

This chart illustrates the average returns for a mutual fund investor over a twenty-year period. At first glance, this seems almost impossible: how could the average investor have earned, on average, less than a 1 % return after inflation, especially when the S&P earned nearly 9%, on average, each year? Surely, the average mutual fund could not have underperformed the index by such a wide margin.

The explanation for the disparity lies in the perils of market timing. Investors who remove money from the markets during down periods, only to reinvest it when they are more comfortable (typically when the markets are on an upswing), lock in their losses while minimizing their chance to enjoy the early days of a strong bull market. Giving in to fear during the worst of a given market cycle may have a significant impact on your ability to reach long-term investing goals.

SMALL AND LARGE CAP PERFORMANCE AFTER RECESSIONS

Of course, when we discuss the historical phenomenon of stock market outperformance in the wake of downturns and recessions, that does not mean that all asset classes performed as strongly as others. This chart illustrates the average performance of two different groups of stocks in the wake of all recessions over the past six-plus decades. In each of the periods examined, small-cap stocks outperformed large-cap stocks, though both classes’ average performance was strong.

Small cap stocks are, of course, more volatile than larger-cap stocks. For that reason, many investors have tended to shy away from investing in this asset class. However, while investment planning that addresses volatility is important, fear of small-cap stocks may not justify omitting them from your portfolio: while small-cap stocks have not outperformed larger stocks after every recession, their average potential outperformance is significant. When investors consider strategies for a post-recession period, diversifying into small-cap stocks may be one option to which they should give special attention.

CRISIS AND OPPORTUNITY

As we come to the end of this installment of Know Risk, we want to tum briefly to the current crisis, and to try to apply some of the lessons imparted by previous downturn and recovery periods in order to begin to see a way forward. As noted above, we cannot yet make too many definitive judgments about the length and severity of our current situation, but we can at least learn a few things about the risks and opportunities that even the initial downturn period of such a crisis can bring.

The chart on the left details the nine most volatile years since 1929-note that 2008 is third on the list, its volatility exceeded only by two of the worst years of the Great Depression. 2008 saw nearly three times the number of volatile days ( defined as a day on which the markets are up or down by 1 % or more) than would be expected in any given year over that period (represented by the median figure of 47). But it’s important to remember that volatility can mean both losses and gains; the chart on the right notes that while 2008 saw two of the worst single-day losses in the last eighty years, it also saw two of the strongest days of gains.

Certainly, these charts are not meant to indicate that losses and gains cancel each other out-clearly, investors lost far more during 2008’s down days than they gained on its up days. But these charts do illustrate an interesting point: even during a crisis in the markets, it can be difficult to say whether removing an investment on a given day could cause investors to miss out on significant gains as soon as the next trading day. Certainly, the same point applies to long-term investing. Recall the mutual fund example we used above: investors as a whole have historically gained far less, over the long term, by trying to time the markets than they would had they maintained their long-term investment discipline.

USING DISCIPLINE TO OVERCOME EMOTION

This final chart does not illustrate some numerical fact, or some quantifiable historical aspect of the markets. However, it does offer a convincing illustration of how emotional reactions to market turmoil can affect investors’ behavior, and thereby impact their returns.

Downturns and Recoveries

This (admittedly unscientific) chart convincingly illustrates the emotional impact that different points in a market cycle can have on the average investor. The high point, “euphoria”, and the low point of “despair” represent the extremes of investor sentiment-what is notable about each is that, historically, they have been equally unwarranted. The euphoric reaction to the peak of a cycle can convince otherwise sensible investors to pour money into a market that is about to cycle downward, whereas despair at the bottom of a cycle can convince that investor to withhold his investments from a market that is poised to post strong gains. But consider the reactions that an investor may have to the other, less extreme points of this cycle: an investor in denial is unlikely to sell out of investments that are in free-fall, while a capitulating investor is likely to sell off his stake in firms that don’t have much further to fall. In the time that it takes for an investor to move from despair to hope, he may miss out on the strongest surge that a given bull market has to offer. As his enthusiasm for investing on an upswing turns to exhilaration, he is as apt to lose his long-term investment discipline as he is when he panics.

All of this history and discussion brings us back to the point of long-term investment discipline. While many institutions and individuals consider themselves to be disciplined, long-term investors, and have worked with their investment advisors to craft sound strategies that are designed to meet their long-term goals, it can be tough to maintain that discipline in the face of market upheavals. After all-we are all only human, and watching the value of a portfolio swing wildly up or down can make it difficult to maintain that discipline. But if there is one thing that you take away from this article, we hope it is this: for most investors, maintaining investment discipline, including regular portfolio evaluations that help to adjust investments to account for new market realities, is the most consistent and reliable way to reach their long-term investment goals.

In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.

Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.

Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.

Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.

Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.

All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.