The long-term performance of stocks is very appealing. Over the past century, US stocks have averaged nearly 9% a year in returns. Investors can quickly forget that these attractive returns also include bear markets, recessions and even the Great Depression.
These frequent pullbacks are why “stocks take the stairs up and the elevator down.” Investors that are aware of these frequent bouts of volatility and paper losses have the opportunity to tailor investments and maximize benefit from changing markets.
How Common Are Bear Markets?
Investment plans built for the long term should factor in the likelihood of a bear market every six years, as noted by research from Capital Group.
With this type of philosophy, investors can start to build plans entering into a bear market. As markets continue to flirt with re-entry into a bear market, we focus ahead on our transition out of the same market.
Research by Verdad Capital has found that certain types of stocks and bonds perform well leading out of recessions. These include indices and companies with characteristics such as value, quality (e.g. consistent earnings). Smaller sized firms also traditionally perform very well leading out of bear markets.
US Stock Market Returns During Bear Market
Interestingly, this chart shows that the US stock market generated 12% during both calm and crisis moments of investing. So simply remaining invested in US stocks does not provide an additional boost in the recovery. Instead, investors looking to benefit from the rebound can achieve additional upside capture through investments in a diverse group of quality, small and value indices.
Research also found that no single index or investment theme always outperforms others leading out of bear markets. Sometimes smaller companies perform very well, as they did after the Dot-Com Bubble. Other times quality stocks perform well, as they did after the Oil Crisis of ’86 and 2008 Global Financial Crisis.
This highlights the importance of maintaining a diversified portfolio into and throughout a bear market. For many investors, this means sticking to the Investment Policy Statement that is generated from their risk tolerance and financial plan. Since bear markets occur so frequently, a well-constructed financial plan will account for investing in bear markets.
Investing in Stocks and Bonds Out of Bear Market
In trying to recover from bear market losses, many investors instantly think of stocks that offer unlimited upside potential. However, investors focused on generating returns should also consider the bond portion of their portfolio. Traditionally, safe, low-yielding government bonds can act as a ballast to riskier high-yield bonds.
Many investors are unaware that high-yield bonds have previously outperformed many other asset classes, including stocks, as markets lead out of a bear market. As the markets become overly pessimistic, the implied default rates on bonds continue to rise. As markets and the economy improve, these bonds continue to pay the same interest payments even as the bond price rises. The result for investors is the ability to “lock-in” interest rate payments.
High-yield bonds performed very well after the 2008 bear market and 2015 oil bear market, as found by Verdad Capital. For this reason, some investors would be wise to consider high-yield bonds in constructing a total return portfolio.
Bear Market Investment Recovery Using Bonds and Stocks
Comparing 2009 performance, we see that the US high yield index had similar losses at the beginning of the year before generating a 29% return overall.
Part of the outsized gains by bonds stem from having lost less than stocks to start the year. High yield bonds actually continued to hold pace with stocks in 2010 when they matched the 11% return of the S&P 500.
High yield bonds average annual returns of 19% when they trade at crisis levels. This return is more than double the typical 8% return in non-crisis environments. This outsized return comes from both the interest rate payment and rebounding bond price.
Discerning investors can even use the sizable interest coupons to reinvest these cash flows into other opportunities such as value, quality and small company indices. These consistent cash flows can help reduce portfolio volatility and diversify the stream of returns.
Investors interested in achieving greater upside capture after bear markets should remember that no single investment strategy, index type, or company characteristic will outperform others. Maintaining diversification across asset types and investments will allow investors to tilt to proven strategies and help to avoid regret from missing out on the market’s returns.
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