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
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 participants need a prudent way to be prepared to weather it rather than adopting an “Armageddon” strategy.
Being prepared for the next bear market
As participants 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 65% 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.
A second worry for those preparing for a bear market in U.S. stocks is that diversifying internationally can’t 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.
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 period and bucketed by quintile using the past 25 years of data. Analysis is from periods 10/31/1993 - 10/31/2018. Data are as of October 31, 2018.
Data from the last 25 years only partly support this concern. Again, looking at only those months in which the S&P500 provided a negative total return, the MSCI-ACWI ex-US 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, long-term interest rates are likely to gradually grind higher, hurting long-term returns.
However, in an old economic expansion and old bull market, participants 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.
For DC plan participants, this balancing act represents a daunting task. In fact, with less than 40% of DC plan participants confident in their ability to make key investment decisions,1 many chose to invest in a professionally managed portfolio such as a target date fund (TDF). For DC plan participants specifically, it is important to remember retirement is often a long-term goal and the effects of a downturn should not derail a well-diversified, professionally managed portfolio.
1 2018 DC Plan Participant Survey Findings – Part 1: Understand the state of the participant.
The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designedas a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions. For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programmesare marketing communications and are not in scope for any MiFID II / MiFIRrequirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research.