Preparing for the Next Market Downturn

As the bull market and economic cycle progress, it’s worth thinking about what a more severe equity pullback might look like and ways you may be able to prepare.

In 2018, investors in U.S. stocks have been experiencing a turbulent stage in a decade-long advance, as the market has generally been supported by stimulus-driven economic and earnings growth. Still, many are wondering how long the positive trend can last, what the backside of the bull market might look like, and what they can do to prepare.

For some who have held onto stock positions over the last nearly 10 years, equities may have grown to outsized portfolio allocations, sometimes with substantial imbedded capital gains. Even if one is willing to absorb the tax cost, diversification choices seem less than ideal. Bond yields are still historically low but rising, creating a headwind for this “anchor-to-windward” asset class. If U.S. stocks are starting to look fairly valued to some, foreign economies are showing slower growth. And amid tech-driven shifts in business dynamics, finding so-called conservative stocks is more difficult. The total picture is one that lends itself to uncertainty and, potentially, emotionally driven decisions at the worst time.

Often the most constructive way to deal with fear is to face it—to understand your enemy, its characteristics and behavior. In the current environment, this means understanding the nature of risks, to better assess the danger of a bear market or correction, and then having a historical perspective on what market pullbacks have looked like in the past. Finally, it’s important to have a strategy in place that accounts for a potential downturn—and subsequent potential recovery.

Gauging Current Risks

To be clear, our central scenario for the U.S. economy and stock market is constructive. The U.S. is likely to grow close to 3% this year, consumer sentiment recently reached a multiyear high and unemployment remains below 4%. The tax cuts have benefited corporate earnings directly and, along with the rollback of Obama-era regulations, have encouraged more capital spending—something that could contribute to increased productivity and enhanced economic growth potential.

Supported by Tax Cuts, Stocks Still Appear Reasonably Valued

S&P 500 Forward Price/Earnings Ratio

Source: Bloomberg, data through September 30, 2018.

At the same time, fiscal stimulus can’t last forever, and the Federal Reserve’s monetary tightening is beginning to be felt—in the upward shift of yields and generally volatile market conditions. At this point, our Global Fixed Income team believes that the fed funds rate is about 75 basis points below a neutral level of 3.0% that provides stable growth and stable prices, although the Fed may move beyond that level if necessary to limit its inflation target to 2%, keeping rate hikes coming through 2019, and perhaps into 2020.

With that in mind, the consensus view is that the economic expansion is likely to continue into 2020, although the timing is hard to predict. Such an outcome, with lagging non-U.S. economies stabilizing and the U.S. gradually pumping the brakes, could allow for further stock market appreciation from here.

That’s a long way from a market-shock scenario, but there is the potential for substantial risks, including worsening inflation that would cause the Federal Reserve to accelerate or lengthen its rate hikes, even as Europe and Japan struggle to gain economic traction; the chance that the trade conflicts deteriorate, cutting into global GDP and potentially contributing to inflation; or that politics-based developments including U.S. governmental paralysis or a “hard Brexit” come to impact financial markets.

What Could a Market Pullback Look Like?

Could any of these factors or a combination of them cause a significant decline in the stock market? Although we don’t think that’s likely in the near term, it’s certainly possible, just as other factors flying below the radar could also provide impetus for declines.

In past market drops, a couple of themes have often been present, including economic malaise (recession, high inflation/monetary tightening and/or imbalances in certain parts of the economy) and geopolitical events (wars and other major crises). In a couple of cases (the ’87 crash and tech bubble), market issues were a cause rather than a symptom (see display). In terms of length, market declines have ranged from just a few months to a couple of years or more, although the period it has taken to recover to the peak has often been substantial, with a median of 28 months and a mean of 54 months.¹ In many cases, it can be unclear initially whether market weakness will be just a correction or something more serious and long-lasting.

U.S. Equity Bear Markets Have Had Multiple Causes

Source: Bloomberg, general news sources, St. Louis Fed, NBC News, The Motley Fool. Drawdown and recovery data is based on the S&P 500 price index (excluding dividends). Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is not indicative of future results.

At What Point Can Interest Rates and Valuations Become a Trigger for a Market Decline?

Interest rates are often cited as contributing to equity downturns, but in our research we have actually found considerable variation in rates leading into difficult periods for the market. It does stand to reason that if rates were to get high enough that would eventually crimp growth and stock appreciation. However, what level has what impact may very much depend on the environment. For example, back in the 1980s, Paul Volcker raised the fed funds rate to as high as 20%, but today, given lower growth expectations overall, it is not well understood what the rate level would have to be in order to ignite a market pullback. Also, rate increases don’t occur in a vacuum. If rates are on the rise, the economy may also be accelerating enough to offset the drag of higher financing costs for companies.

By the same token, valuations are also commonly viewed as a culprit for exhausting a bull market, but again they have varied a great deal prior to bear markets. It is common sense that you should avoid overpaying for an investment, and that excessive valuation can be an indication of potential future loss. But you wouldn’t necessarily see a decline because of price. Rather, valuation is a danger that may be exacerbated by some other trigger. Moreover price alone can be deceiving; for example, late in an expansion, cyclical companies may have modest price/earnings ratios, which skyrocket when earnings evaporate in the next downturn.

So, rather than consider rates and valuations in isolation, we think that economic and company fundamentals provide more meaningful indicators of the market’s potential direction. For example, the chart below pairs the one-year trailing return of the S&P 500 with two widely followed measures of economic activity (placed at the end of the corresponding one-year return). As you can see, their relationship is fairly tight, which may reflect markets’ anticipation of economic trends.

Economic Fundamentals Have Been a Strong Indicator of Market Direction

S&P 500 Return vs. Purchasing Managers’ Indices (PMI)

Source: Bloomberg. Data through September 30, 2018. Based on total return data for the S&P 500 Index. PMI is the average of the Manufacturing and Non-Manufacturing PMI. All Figures above 50 indicate expansion. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is not indicative of future results.

This pattern has often been echoed in the behavior of the stock market in relation to recessions, with market declines tending to emerge as economic conditions begin to deteriorate (i.e., sometimes six to 12 months prior to when a recession is actually declared by the National Bureau of Economic Research).

Markets Have Often Peaked Just Prior to Recession

Source: Bloomberg, NBER. Data through September 30, 2018. Based on monthly total return data for the S&P 500 Index. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is not indicative of future results.

Becoming a Market-Pullback Preparer

With some understanding of the nature of past market declines, including their variation and link to fundamentals, what can you do to prepare?

One constructive step is to take a fresh look at your strategic asset allocation—the long-term structure of your portfolio—to make sure it is aligned with your risk tolerance, investment objectives (i.e., balanced between income requirements and capital appreciation or growth) and time horizon. As part of this, you should have some understanding of how your portfolio may behave in a downturn, keeping in mind that higher risk exposures may trigger greater short-term declines, but also carry greater long-term return potential if you are able to remain invested and withstand periodic market shocks.

To illustrate, the table below presents the average performance of simple stock/bond allocations across five major equity drawdowns between 1980 and 2009. As shown, the more aggressive a portfolio, the longer the time before it recovered from the downturn. On the other hand, the portfolio with the largest weighting in stocks had the highest annual return of all the allocations over the long term.

Asset Allocation Tradeoff

Average Stock/Bond Performance During Five Most Recent Severe Downturns (1980–82, 1987, 1990, 2000–02 and 2007–09)

Source: Neuberger Berman, FactSet. Specific periods covered: Nov. 1980 – Aug. 1982, Aug. – Dec. 1987, July – Oct. 1990, Mar. 2000 – Oct. 2002, and Oct. 2007 – Mar. 2009. Based on monthly total return data (including dividends and interest income) for the S&P 500 Index and the Barclays Aggregate Index. Peak-to-trough returns may be different than if they had been computed using daily data. Portfolios are composed of the S&P 500 and Barclays Aggregate data in the percentages in each portfolio’s allocation as illustrated in the table. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is not indicative of future results.

Another “to-do” is to consider tactical tilts to address current short-term risks and opportunities, for example shortening bond duration when further interest rate hikes are anticipated, or trimming cyclical stocks in favor of less vulnerable consumer staple stocks as the economy moves out of a late-cycle surge in output. Admittedly, realizing some capital gains at the margin and related tax payments may be a result of this.

Furthermore, investors may consider the use of a broader array of hedging strategies to seek differentiated return potential and potentially provide some risk mitigation. For example, long-short equity funds can potentially be an effective way to generate equity-like returns with less volatility. And private equity strategies can provide an illiquidity premium for long-term use of investor assets, while low volatility hedge funds can add ballast to portfolios in turbulent markets.

Making the Market Work for You

While it’s sensible to think about the potential for a market pullback, it’s also important to understand that historically the stock market has risen the vast majority of the time—about 70% of the years since the 1929 crash. Bull markets have tended to last far longer and have had far greater magnitudes than periods of market weakness (as shown). Furthermore, the compounding effect of a commitment to equities for the long term can be a powerful source of wealth enhancement. As such, you may want to consider trying to make this dynamic work for you as much as possible by generally remaining invested, even if it means the prospect of taking some unpalatable price declines along the way.

One thing to avoid, in our view, is any precipitous decisions about your portfolio. It’s easy enough in retrospect to wish you had left the market or moved in at just the right moment, but market timing is notoriously difficult and typically counterproductive. We believe that having a well-constructed, diversified portfolio based on an established long-term asset allocation framework is an ideal way to work through a downturn and set the table on the other side for long-term appreciation potential.

Bull Markets Have Been Longer, With Greater Magnitude, Than Bear Markets

Source: Bloomberg, Neuberger Berman, Yardeni. Data through September 30, 2018. Based on monthly return data for the S&P 500 Index, without dividends until 1970 and including dividends from 1970 onward. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is not indicative of future results.