A look at past bear markets and implications for the future

The S&P 500 is officially in a bear market, and the crash from the high valuation levels has been fast and painful. There is however light at the end of the tunnel. In this post I’ll demonstrate how the US stock market has developed during past bear markets and how the market has recovered during the ten years after the peak.

The reason for choosing the ten years as the horizon is because I believe that you should not invest in stocks any money that you are going to need in the next ten years. The chance of having positive returns increases substantially with time and is almost ninety percent for a period of ten years. The worst annual return for a ten-year period has been about negative four percent since 1928 (sources).

We’ll use monthly total return data of S&P 500 from Shiller beginning from the year 1871 until the very end of last year. The index has been reconstructed to represent the US stock market for dates the S&P 500 didn’t exist yet. The reason why we go so far back in time is to include as many bear markets as possible. Panics and manias have always existed, and the human nature has not changed enough in the past 150 years to make the past data less valid. There has however been a substantial change in the spread of information, which causes panic to spread faster and may possibly make bear markets shorter and deeper.

First, let’s take a look at the 14 bear markets found in the data in nominal terms, which describes how a portfolio would have developed without taking inflation into account. The horizontal black line indicates the drop needed to reach a bear market at minus 20 percent, and a blue color indicates that the return has been positive in the 10 years following the peak i.e. the ending value is higher than the value at the peak, and a red color indicates the opposite.

Only two of the fourteen bear markets did not recover in ten years from the initial peak. Not surprisingly, the two bear markets were the ones that peaked at bubble territory in 1929 and 2000. Notice that the bear markets that peaked in 1919 and 1987 we followed by the exact same bubbles.

Below is the same plot with real returns, so the returns describe the actual change of purchasing power by taking inflation into account. Notice that since bear markets are defined as being down by twenty percent in nominal terms, the returns might not dip below the black line because of deflation.

In real terms, four of the fourteen bear markets did not recover after ten years of peaking. Judging by the history, this still leaves us an over 70 percent chance of the index being higher in the next ten years after inflation. Note that the bear market that peaked in 1968 is overlapping heavily with the bear market that peaked in 1972, so they could be considered to be the same bear market, which would increase our chances even further.

Let’s then plot the bear markets in red on top of the index to get a sense of the lengths of the bear markets, from peak to full recovery.

The average length of a bear market from peak until recovery has been 3.95 years and the fall length from the peak until bottom i.e. a peak to trough time was 1.45 years. The longest bear market during the 1930s Great Depression was 15.33 years, and the longest time the stock market fell was 2.75 years.

Lastly, let’s take a look at just the drawdowns. The bear market threshold is again indicated with a black horizontal line. The monthly data is only until the end of the year 2019, so the recent drawdown of early 2020 is missing from the graph. At the time of writing, the index is down 27 percent, with only seven of the historical drawdowns being as severe as this one.

The average drop in a bear market using monthly data has been 33.9 percent, with a maximum of 81.8 percent during the 1930s. Notice again that these are total returns. The drawdowns have been worse during periods with high valuations, as measured by Shiller CAPE or P/B. The maximum drawdowns seem to have also increased with time, which may be caused by lower valuations at the beginning of the time frame and possibly also because people have been more connected than ever, which makes the spread of panic easier.

To conclude, this bear market has been rough and short this far. However, judging by the history, most bear markets recover fully in ten years. The valuations that are still elevated compared to history may however make the index to not to recover as much as in past bear markets.

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The R code used in the analysis can be found here.