Source: FactSet, NBER, Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management.
*A bear market is defined as a 20% or more decline from the previous market high. The bear return is the peak to trough return over the cycle. Market returns are price returns. Guide to the Markets – U.S. Data are as of October 31, 2018.
In July 2018, the U.S. economy entered the tenth year of the current economic expansion and given that it is now the second longest in U.S. history, many are asking how much longer it can last.
Statistically, this is a very difficult question to answer. Based on historical analysis over the last few decades, the chances of entering recession in any given quarter is less than 5%. This means that over a year, the probability is less than 20% and over three years the risk is generally less than 60%. And this is, for the most part, the right way to look at it. However, there is good reason to believe that the economy is generally more vulnerable to recession late in a cycle and when it has low unemployment.
This is because later in a cycle, there is a lack of pent up demand, greater difficulty in finding workers to staff open positions and often higher interest rates as the Fed seeks to head off inflation and asset bubbles. All of these problems are, to some extent, present in the current environment. However, in addition, the economy in 2018 was boosted by substantial fiscal stimulus. As that effect fades in 2019 and 2020 the economy should grow more slowly and slow growth combined with some exogenous shock could trigger a recession, with the risk rising in late 2019 and 2020. Such a recession could also be expected to result in a sharp stock market decline.
Sizing up the next bear market
While there is a good chance that the U.S. economy could see both a recession and an equity bear market in the next few years, it is important to have a realistic perspective on the magnitude of both. This may be difficult for some investors since the last recession was the single biggest recession in the post-WWII era and the last two bear markets in U.S. stocks each saw declines of roughly 50%
On the issue of recession, it needs to be recognized that, despite the Great Financial Crisis, the economy has actually been getting more stable over time. This can be seen in the diminished quarter-to-quarter volatility in real GDP and our research suggests that better inventory management, a more stable housing sector and the growth of the more stable services sectors have all contributed to this trend. However, this also suggests that the next recession is more likely to resemble the relatively mild recessions of 1990 and 2001, than the monster recession of 2007-2009.
Exhibit 2: The great depression and post-war recessions
Length and severity of recession
Source: NBER, BEA, J.P. Morgan Asset Management. Bubble size reflects the severity of the recession, which is calculated as the decline in real GDP from the peak quarter to the trough quarter except in the case of the Great Depression, where it is calculated from the peak year (1929) to the trough year (1933), due to a lack of available quarterly data. Guide to the Markets – U.S. Data are as of October 31, 2018.
In similar fashion, the next bear market should not be as fierce as the last two. In the last two bear markets the U.S. stock market fell by an average of 50%. However, in the previous nine recessions, the average stock market decline has been just 24%. This makes intuitive sense – the last stock market tumble occurred against a backdrop of the single biggest recession since the Great Depression, while the stock market entered the previous bear market with valuations that were a full 50% higher than the average forward P/E over the last 25 years
Exhibit 3: S&P 500 index: forward P/E ratio
Source: FactSet, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management.
Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since December 1989, and FactSet for October 31, 2018. Guide to the Markets – U.S. Data are as of October31, 2018.
If the next bear market is indeed serious but not catastrophic, then investors need a prudent way to be prepared to weather it rather than adopting an “Armageddon” strategy.
Being prepared for the next bear market
As investors consider how to be prepared for the next U.S. equity bear market, it is important to recognize that this involves melding together two separate strategies: (1) how to get the best, risk-adjusted returns before the onset of a bear market and (2) how to be as prepared as possible when the bear market actually occurs.
On the second strategy, the traditional advice in entering a bear market is to have a heavy allocation to Treasury bonds. Some fear that this time around, given very low interest rates already, Treasuries have less potential to act as an offset to equity market losses. However, as can be seen in
Exhibit 4, recent history does not support this fear.
We use monthly data from the last 25 years and restricted our analysis to those months in which the S&P500 provided a negative total return. Then grouping those months into quintiles by the prevailing level of interest rates at the time, we ask the question: how much could portfolio losses be reduced by moving from a stocks-only portfolio to a 50/50 equity/Treasury portfolio. The answer is total portfolio losses can be reduced by between 51% and 64% across the quintiles but the offset appears to be independent of the prevailing level of interest rates. The reason for this is clear enough – even though the coupon payments on bonds are lower at lower interest rates, the duration of bond portfolios is longer, allowing for greater capital gains when interest rates fall. The upshot of this is that Treasuries are still positioned to provide some protection in a bear market for stocks.
Exhibit 4: U.S. treasury bond buffer in down equity markets by interest rate quintile
Monthly returns, past 25 years
Source: Bloomberg, Barclays, Standard & Poor's, FactSet, J.P. Morgan Asset Management. Treasury returns are based on Bloomberg Barclays US Aggregate Government - Treasury total return index. Equity returns are based on S&P 500 total return index. Interest rate quintiles are based on the average yield-to-worst over a given month and bucketed by quintile using the past 25 years of data. Analysis is from periods 7/31/1993 - 7/31/2018. Data are as of July 31, 2018.
A second worry for those preparing for a bear market in U.S. stocks is that diversifying internationally cannot work since, metaphorically, when the U.S. sneezes, the rest of the world catches a cold. In other words, in a bear market for U.S. stocks, international stocks do even worse.
Data from the last 25 years only partly support this contention. Again, looking at only those months in which the S&P 500 provided a negative total return, the MSCI AC World ex. USA generally fell by the same amount as the U.S. whether the U.S. drop was small or large
(Exhibit 5). Thus, the reality is that when the U.S. catches a cold, the rest of the world catches a cold as well.
Exhibit 5: MSCI AC world ex. USA and S&P monthly returns in down U.S. markets
Total return indices, U.S. dollar
Source: FactSet, MSCI, Standard & Poor's, J.P. Morgan Asset Management. Data are as of October 31, 2018.
In short, there is little evidence to suggest that bonds will provide less protection or that international stocks will provide more protection in the next bear market than in its predecessors. However, there still may be good reason for a fixed income underweight and an international overweight today. Stock market volatility through the fourth quarter of 2018 has driven international stocks to their cheapest levels relative to their domestic counterparts over the past two decades and both EM and Europe should have more room to grow from an economic perspective. Meanwhile, as the Federal Reserve continues to tighten policy, long-term interest rates are likely to rise, hurting long-term returns.
However, in an old economic expansion and old bull market, investors should maintain flexibility in allocations. It would not take much of a further increase in interest rates or stock prices to justify a neutral allocation between stocks and bonds and the international equity environment is also rapidly evolving.
I was in a meeting recently discussing asset allocation when a much-esteemed British colleague suggested that a certain strategy was like “fixing the roof while the sun shines”. Growing up in agricultural Ireland, I had always heard something slightly different, namely that you should “make hay while the sun shines”. So which is it? Given a still relatively sunny financial environment, should investors be actively preparing for the next storm or busily accumulating winnings while they have the chance? The answer, of course, is a bit of both.