What Happens Next?
Analysts, commentators, and managers are all taking turns making predictions about where financial markets will bottom. While modern markets have never faced a global health pandemic with the magnitude of COVID-19, history is filled with examples of unexpected headlines and “Black Swan” events that take analysts and investors by surprise. In fact, that’s how most Bear markets begin. In volatility-charged markets such as these, it helps to take a step back and survey the bigger picture.
No one likes Bear markets. They are chaotic, volatile, and emotionally exhausting. Bear markets are also inevitable and a key part of financial market cycles. In 2016 we authored a short piece called the Bear Market Road Map that highlights several characteristics of Bear markets that make them unique to any other market climate. While Bear markets should be respected, they need not be feared. Addressing these attributes is a crucial ingredient in our risk management process, and how our funds are designed to diversify, hedge, and even profit from the inevitable Bear market.
Whether the Bear market bottom is just around the corner or months away, here is what you can expect next.
Expect Indecision: Large One-Day Moves
Most investors associate large rallies with Bull markets, and large declines with Bear markets. It may come as a surprise to learn that Bear markets deliver many of the most powerful one day rallies on record. Bull markets are characterized by day after day of small gains that eventually turn into weeks and months of positive returns. In Bear markets, the pace of trading is much more erratic. Economic data and headlines have an out-sized impact on daily, even hourly market prices. The schizophrenic nature of Bear markets makes them challenging for both Bulls and Bears alike.
This contributes to something we call “Volatility Clustering,” a condition where large single-day advances and large single-day declines tend to occur within days of each other. We will have more to share regarding Volatility Clustering in a future commentary. This phenomenon of significant daily price reversals is a defining characteristic of Bear markets, and something we are witnessing so far in 2020.
This contributes to something we call “Volatility Clustering.”
Volatility Clustering is a condition where large single-day advances and large single-day declines tend to occur within days of each other. We will have more to share regarding Volatility Clustering in a future commentary. This phenomenon of significant daily price reversals is a defining characteristic of Bear markets, and something we are witnessing so far in 2020.
To demonstrate this behavior of large single day rallies and declines, we took a look at the 50 largest single day moves in the S&P 500 Index over the past forty years. For simplicity’s sake we defined a Bear market as any time the S&P 500 Index is trading at prices below its 200 Day Simple Moving Average. Since 1980, ninety percent of the fifty largest one-day percentage gains occurred during Bear markets, not Bull. And eighty-six percent of the fifty largest single-day declines also occurred during Bear markets.
Where Do the Largest Days Occur: Bull or Bear?
S&P 500 INDEX: 1980 – 3/31/2020
Top 50 Largest One Day Gains
- Just 5 out of 50 of the largest single day advances occur in Bull markets
- 45 out of 50 of the largest single day advances occur in Bear markets
Top 50 Largest One Day Declines
- Just 7 out of 50 of the largest single day declines occur in Bull markets
- 43 out of 50 of the largest single day declines occur in Bear markets
Expect Noise
The massive single-day rallies and declines in the study above contribute to the chaotic feeling during Bear markets. Financial markets are often referred to as a “discounting mechanism”, the premise that markets assimilate all currently available information including present and potential future events and reflects those estimates in current prices. Stock market valuations do a relatively good job reflecting future economic outcomes during low volatility periods where information flow is relatively calm.
When financial markets are faced with unexpected headlines, the pace of trading quickens, and so does the volatility. Investors are forced to reevaluate security prices at an ever-faster pace to account for new information. Faster markets lead to price dislocation and daily reversals as the information flow changes. Fast, indecisive markets are a defining characteristic of Bear markets. In his 2001 book “Fooled by Randomness,” Nassim Taleb describes these unexpected events as “Black Swans,” an unpredictable, statistically rare event that creates havoc in financial markets. Our study of rolling thirty sixty and ninety-day volatility below illustrates this point.
Volatility Doubles in Bear Markets
S&P 500 INDEX: 1990 – 3/31/2020
S&P 500 Index
Avg 30 Day Volatility
Bull Market: 12.8%
Bear Market: 23.8%
S&P 500 Index
Avg 30 Day Volatility
Bull Market: 12.8%
Bear Market: 23.8%
S&P 500 Index
Avg 30 Day Volatility
Bull Market: 12.8%
Bear Market: 23.8%
Source: Anchor Capital, Bloomberg, L.P.
Navigating the Bear
The last three Bear markets in the U.S. averaged losses of more than fifty percent, with even more significant declines abroad. The current Bear market driven by the COVID-19 pandemic however goes beyond the potential financial impact of past Bear market declines. At best, it will be a disruption in our lives and our economy, but for many families it will be much worse. Our thoughts and prayers go out to those who are fighting for their own family’s health.
Bear markets are inevitable, but they don’t have to be destructive to client portfolios. Positive returns during Bear markets requires a different investment approach then Bull market investing. That’s why our risk-management process accounts for changes in short term volatility as well as long-term trends, helping us pursue our objective of consistently positive returns, even in Bear markets.
