Bear Markets Lay the Foundation for Bull Markets

A falling stock market, high inflation, rising rates, recession debates, and the worst consumer sentiment in decades – the backdrop makes it hard to find anything to be positive about.

I won’t litigate all the above, but will share some good news.  Mind-numbing losses have historically been a pre-cursor to great future returns.

Look at the average returns following every 20% drawdown in the S&P 500 since the Great Depression.

Cutting right to the chase – historical evidence overwhelmingly points to strong future returns after entering bear markets.

On average, once we enter a bear market, the market gains 16% over the next year and 13% annually over the next 3-5 years. And those numbers include any additional losses suffered after entering the 20% drawdown! 

Even in a recession scenario, the story doesn’t change – future returns remain strong.   

Looking at only the subset of bear markets that included recessions, future returns are actually stronger than bear markets without a recession.  The market averaged a 19% return over the next year in recessionary periods and between a 12-14% return over the 3-year and 5-year periods post-recession. 

To be clear, the recession scenario does carry more downside in the short-term and takes longer for the market to officially bottom, but you make up for it on the other side.  The recession scenarios also contain the “worst case” outcomes: the 2008 crisis and 1973 period of stagflation. 

Both those periods saw 20%+ declines in the 1-year period after entering a bear market.

Providing some context around both periods, it seems unlikely we’re headed for a repeat of 2008.  The banking system is significantly more capitalized and less leveraged today versus then.  And the adjustable-rate mortgages, which caused chaos in 2008, only represent roughly 4% of the total outstanding mortgages today.

The 1973 comparison versus today should not be totally dismissed given high inflation was a significant driving force then as well.  Inflation peaked around 12% in the mid-1970s; we’re still a ways off at our current inflation rate of 8.6% today.   But during that terrible period, the 3-year and 5-year returns were still 5% and 7%, respectively.  Not a terrible outcome for one of the worst periods in market history.

One data point that is fascinating: there is zero precedent for losing money over 5-years after entering a bear market! 

While that alone doesn’t guarantee success, it certainly indicates the odds are heavily leaning one way.  It’s almost like stepping up to a blackjack table where the dealer exclusively deals you face cards while they deal themselves the entire deck.   If you stick around awhile, you should be rewarded.

This is a “gut check” period for markets.  For many, it likely feels like a fools errand to continue investing.  There will probably be more days where we wonder if the market will ever go back up.  Much of the economic data has been terrible and could continue to get worse.  The negative sentiment will breed even more pessimism.

But over long periods, a significant chunk of our investment performance comes from how we handle these moments.  The biggest risk of all could be our instincts to react to the short-term pain rather than the long-term evidence.