The equity markets are continuing to digest uncertainty brought on by COVID-19, oil markets, and bond yield volatility. During these times of market stress, we find it important to provide timely communication regarding the financial market landscape. Although it may be easy to focus on the negatives associated with these events, we would like to provide more balanced insight into bear markets and the state of the equity markets. We feel that this information provides several positive reminders regarding stock market investing as well as key reasons why stocks are becoming increasingly attractive in the midst of this volatility.
Bear Markets are Normal
- Bear markets are normal and healthy. It is not reasonable to think that stocks can rise dramatically without certain large negative years.
- Bear markets are defined as losses of 20% or more and have occurred 15 times since 1926 which is approximately one in every 6 years (Footnote 1).
- The one-year return following a bear market has been roughly 47% (Footnote 1).
- Most bear markets have unique or unprecedented events that trigger the decline; however, each bear market itself is not “different this time.”
Event-Driven Bear Markets Often Rebound Quickly
- Every bear market has an emotionally-driven element; however, bear markets are typically triggered by either structural factors OR event-driven factors (specific events that shock markets).
- Structural bear markets tend to have greater magnitude relative to event-driven bear markets.
- Structural Bear Market Average Decline: -57% (Footnote 2).
- Event-driven (cyclical) Bear Market Average Decline: -31% (Footnote 2).
- The average duration and recovery time of structural bear markets is approximately five times that of event-driven bear markets (Footnote 2).
- 2008 had significant structural problems associated with financial institutions. We are not seeing these types of issues in the current environment. This bear market appears to be highly event-driven (resulting from COVID-19, then coupled with a shock to oil prices).
- We need to let the markets process the recent uncertainty and let the emotion play out. This may take time but we feel will leave us with a fundamentally strong environment for equities
Equity Markets are Quickly Becoming Increasingly Attractive
- COVID-19 triggered near-maximum pessimism. Markets are a leading indicator and have been quickly pricing in near-maximum pessimism caused by the virus. Fear of the unknown is often the greatest fear, and much of this is already being priced into stocks. Yes, there may be additional deaths, event closures, and other economic impacts, but some level of this is already expected by investors and reflected in market prices. Similar to how stock prices declined ahead of an economic slowdown, stock prices generally rise ahead of an economic expansion. Although it may be uncomfortable to increase equity exposure during uncertain economic times, this strategy may lead to outperformance over the long-term.
- Real economic impact of COVID-19 vs. stock market declines. Reaction to this virus has caused tangible declines in growth output which will understandably have an impact on stock prices. Yet the global equity markets have declined to the tune of trillions of dollars, which is extreme. We feel this decline is over-inflated relative to the actual economic disruption caused by the virus. The economic disruption is temporary and is expected to stabilize once the uncertainty surrounding the virus dissipates. Yet we have discounted equity prices that can create attractive investment opportunities.
- Interest rates have been decreased to the lowest level in years. Through two fastpaced rate cuts, the Federal Reserve has brought the Fed Funds Rate to near-zero levels, similar to 2008. This creates two themes that are beneficial for equities. First, cost of borrowing for consumers and businesses has been reduced. Lower cost of borrowing reduces expenses and encourages spending, which historically has been beneficial for the economy. Second, bonds have low rates creating very little competition for stocks. The broad equity market has increasingly attractive characteristics relative to many bonds, such as higher dividend yields compared to treasury bond yields.
- Oil prices have been volatile but are at the lowest level in years. The recent oil price shock created additional fear and uncertainty in the broad financial markets. This had an immediate negative impact on stock prices. Although this is still a challenge for energy-related companies, low oil prices are beneficial for many other types of business as well as consumers. Again, this may spur additional economic activity as uncertainty begins to diminish.
- Fiscal policy is a tool that remains in the toolkit. Monetary policy is an important tool used by central banks to spur economic growth (reflected in the current near-zero interest rates). Although monetary policy tools may be exhausted, fiscal policy is another important tool. Global governments will likely be aggressive in using government spending to initiate economic growth. We are already seeing this develop around the world. Because the stock markets forecast economic growth, any news of fiscal policy initiatives will likely be positive news for equities.
How to Benefit from Bear Markets
- Remain Disciplined. Since bear markets are normal, we have already planned for this potential outcome through the financial planning process and portfolio management process. Equities provide extremely valuable benefits to well-diversified portfolios. Making radical changes in the midst of normal market volatility can be destructive to your portfolio and in your ability to reach your financial goals. Our clearly-defined investment principles guide our portfolio management process in an attempt to manage risk and provide excess return over the long-term.
- Remain Opportunistic. Our investment principles introduce discipline into the portfolio management process, and part of that process is to seek opportunities for improved return. This may involve buying investments at a time of market stress and uncertainty, which may initially feel uncomfortable yet could result in additional return opportunities.
- Proactively Manage Tax Liability. Certain tax management strategies may prove effective during times of market decline. Tax loss harvesting for example is the practice of selling positions at a loss to realize capital losses with the goal of using those losses to offset current or future realized capital gains.
- Consider ROTH Conversion. ROTH conversion is the process of distributing funds from traditional IRAs, paying the income tax, and transferring the proceeds to ROTH IRAs. During times of low market prices, ROTH conversions may become more attractive. Initiating a ROTH conversion when markets are low may position you to have increased appreciation in your ROTH IRA, which may be more beneficial relative to maintaining funds in traditional IRA ownership.
- Control Cash Flow. During times of market volatility, it is important to focus on the things that you can control. If you are in the accumulation phase of your financial journey, it may be a good time to increase your contributions. Conversely, if you are in retirement, you may have flexibility to reduce expenses. These small changes have the potential of adding value to your financial plan over the long-term.
Footnote 1: https://www.fidelity.com/
viewpoints/market-and- economic-insights/bear- markets-the-business-cycle- explained