Bear Markets are Common and Offer Higher Expected Returns
Last night the US stockmarket officially became a ‘bear’ market, meaning the market has fallen 20% from the recent high. The Australian stock market has performed marginally better, being down 12% since the beginning of 2022.
Stockmarkets have fallen because investors are wary of an economic downturn driven by rising inflation. In turn, inflation is being driven by COVID-related disruptions to supply chains and the war in Ukraine impacting energy prices. In May, US inflation over the prior 12 months was 8.6% - the highest year-over-year growth since December 1981. The items most impacted by inflation have been petrol prices (+48.7%), airline fares (+37.8%) and gas utilities (+30.2%).
Interest rates are expected to rise to help curb inflation. Last week the Reserve Bank of Australia (RBA) increased the cash rate by 0.50% to 0.75% in response to our 12-month inflation rate being 5.1% to 31 March 2022. The cash rate is the benchmark against which home loan rates and term deposit rates are set.
The RBA expects inflation to increase further, perhaps to 6%, but then decline back towards its 2–3 per cent target range in 2023. As the global supply-side problems are resolved and commodity prices stabilise, even if at a high level, inflation is expected to moderate.
The RBA noted the Australian economy is resilient, growing by 3.3% over the past year, and household and business balance sheets are generally in good shape with an upswing in business investment underway.
Whilst sudden market downturns can be unsettling, historically sharemarket returns following sharp declines have been positive. A broad market index tracking data since 1926 in the US shows that stocks have tended to deliver positive returns over one-year, three-year, and five-year periods following steep declines. Cumulative returns show this trend to striking effect, as seen below.
Source: Fama/French Total US Market Research Index Returns, July 1926-December 2021
On average, just one year after a market decline of 10%, stocks rebounded 12.5%, and a year after 20% and 30% declines, the cumulative returns topped 20%. Over three years, stocks bounced back more than 30% from declines of 10% and 20%, although—while still positive—returns were not as impressive after 30% declines. But five years after market declines of 10%, 20%, and 30%, the average cumulative returns all top 50%.
A look at the data makes a case for sticking with a plan. Handsome rebounds after steep declines can help put investors in position to capture the long-term benefits the markets offer. When prices fall, the expected return goes up.
It has been unusual that we have experienced two markets falls of 20%+ in the last two years. Historically, falls of this size have been more dispersed. When the pandemic impacted stockmarkets two years ago, we wrote an article showing that since 1939, there have been 16 market falls of 20% or more. The current 20% fall is number 17. This equates to, on average, one 20% fall every 5 years. We would thus describe this current volatility as uncomfortable but normal. Whilst the catalyst for each market episode differed, there is no “new normal” about market volatility.
You can review our article from March 2020 to see how quickly markets rebounded after each 20% fall - https://loricapartners.com.au/insights/2020/3/17/covid-19-update-no3-s36w9. Whilst the timeframe varies, they have always bounced back, and sometimes quickly. You need to ensure you are in your seat when the rebound arrives otherwise you can miss substantial returns.
There is a lot happening in the world at present but staying the course with the investment strategy Lorica Partners has created for you is the best decision. When developing your investment strategy, we expect and plan for times like these.
Author: Rick Walker