Every cloud has a silver lining

Every cloud has a silver lining and working at home has presented a few. I’ve learned that a 7am walk into the deserted countryside is a much better start to the day than the 6.45 to Blackfriars; I’m fast catching up with my kids on the technology front; and the accumulated wisdom in my collection of investment classics is just an arm’s length away. How refreshing to be away from the sterile new world of paper-free hot desks where what you need is never quite at hand.

The appearance of the first bear market in 12 years has naturally had me seeking lessons from the past and there is no better guide than Russell Napier’s magisterial study of the four great market slumps of the 20th century: Anatomy of the Bear. Dipping into it again has reminded me that what we are going through as investors today is quite different from the experience at the market lows he pinpointed in 1921, 1932, 1949 and 1982. It is much more like the dramatic but short-lived market event of 1987.

This insight was confirmed by an excellent analysis of bear markets by Goldman Sachs’s strategist Peter Oppenheimer. He has gone even further than Napier, trawling through 200 years of the market’s ups and downs in search of patterns that might help us work out where we go from here. His analysis, too, suggests that the catch-all definition of a bear market - a fall from peak to trough of at least 20pc - is too blunt an instrument to capture the different flavours of market downturn.

The four bear markets in Napier’s study may have been associated with crashes like that on Wall Street in 1929 but they tended to be much slower burn episodes than these traumatic but short-lived events. 

It usually takes a long time for shares to travel from peaks of overvaluation to the market lows, despair, bankruptcies and general revulsion towards investments that marks the start of the next bull market.

If the current period of market volatility turns into one of these deep structural bear markets, then we are clearly a long way from the bottom. There are few of the signs that typically characterise a market’s low water mark. You know the end of a bear market is near when investors ignore good economic news, when bullish commentators are ridiculed or ignored, when the pundits that are listened to suggest that the worsening situation will prevent both an economic recovery and a bull market for shares.

The bottom of a bear market is marked by a sense of lethargy, a final slump in prices on low volumes and widespread short positions in beaten up shares. We are nowhere near this situation today, which pessimists will see as an indication that the floor remains a long way below us. There have, after all, been eight occasions since the 1830s when share prices have halved from their previous peak and at the worst a week ago the hardest hit markets were down by no more than a third.

Optimists will conclude, on the other hand, that this is not really a bear market at all but a nasty, and unusually rapid, correction triggered by a wholly unpredictable exogenous shock. They will assume, as many investors clearly did during last week’s big rally, that prompt and massive fiscal and monetary support will quickly put us back on track. I suspect the answer lies somewhere between these two readings.

Oppenheimer distinguishes between three different types of bear market. They result in very different outcomes for investors both in terms of the scale of losses experienced and the length of time taken to recover. The first category, the structural bear market, triggered by imbalances and financial bubbles, is closest to the slumps in Napier’s study. On average these result in a peak to trough fall of 57pc and it takes 111 months, more than nine years, for investors to recoup their losses.

The second category is the cyclical bear market. This is typically caused by rising interest rates bearing down on economic activity, pushing unemployment higher and triggering a sharp all in profits. These types of bear market were much more common in the period before first central banks and then governments changed tack from fighting inflation to preventing depressions. The average sell-off in these bears was 31pc and recovery was achieved after around four years.

By far the most benign type of bear market is the one that meets the 20pc definition but falls short on the other softer characteristics. These event-driven ‘bear’ markets are triggered by shocks that do not necessarily lead to a recession, such as an oil-price spike, an emerging market debt crisis, or some kind of technical market glitch. The price falls associated with these kinds of events can be painful - 29pc on average - but recovery is much quicker, just 15 months or so.

Key to whether this correction ends up being one of these bracing, but relatively harmless, routs is, first, how effective the various massive fiscal and monetary stimulus packages turn out to be in preventing long-lasting damage to profits and jobs. Second, it depends on whether Europe and the US follow the Asian template of effective suppression of Covid-19 followed by a rapid return to business as usual. The jury is out.

The dramatic market rebound last week is par for the course in a bear market. It should be enjoyed but not taken too seriously. There may be another leg lower from here. But there is good reason to hope that the right policy response, and the underlying health of the pre-corona economy, mean this turns out to be a short and sharp correction and not the raw material for Napier’s bear market sequel.

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