Corrections and bear markets: What does Vanguard think?

OREANDA-NEWS. February 03, 2016. From their high on May 21, 2015, global stock prices lost about 19% of their value through January 20, 2016. The setback qualifies as a "correction," which is conventionally defined as a decline of 10% or more. The term "bear market" typically refers to a decline of 20% or more lasting at least two months.

Corrections are common

Stock market downturns—corrections and bear markets—are relatively common. Since 1980, the global stock market¹ has experienced 12 corrections and 7 bear markets—on average, an attention-grabbing downturn every 2 years or so. Over the past 36 years, stock prices have spent almost 30% of the trading days in corrections or bear markets.

(Note: This analysis considers price returns only. In a total return analysis, returns would be higher, and recoveries quicker, because of reinvested dividends.)

Global Stock Prices (January 1, 1980–January 22, 2016)

A similar story emerges from an analysis of the U.S. stock market's more extensive historical data. Since 1928, the Standard & Poor's 500 Index has spent 40% of the roughly 88-year span in some sort of setback—a correction or bear market. Over that same period, however, the index has produced an average annualized return of about 10%, outperforming lower-risk assets such as bonds and cash^.2 The stock market's occasional—and occasionally severe—setbacks were the price investors paid to realize long-term returns superior to those of the lower-risk assets.

Depths and duration have varied

Some corrections are swift, others grind lower slowly. The time from a market trough to recovery has been similarly unpredictable. Consider a few observations from the global stock market data:

• The average number of days from the start of a correction to its bottom was 87 days. The fastest decline was 28 days, while the slowest was 124 days.
• The average number of days from a correction's trough to recovery was 121 days. The speediest rally was 46 days, the slowest 359 days.

Bear markets have generally taken longer to reach a bottom and longer to recover.

• The average number of days from the start of a bear market to its bottom was 373 days. The fastest decline was 60 days, while the slowest was 926 days.
• The average number of days from a bear market trough to recovery was 798 days. The quickest recovery was 85 days, the slowest 1,928 days.

Surprising and inevitable

The bold-faced headlines announcing each downturn make the turmoil seem shocking. That's true to an extent. In each correction or bear market, a surprise catalyst disturbs the status quo. At the same time, the setbacks are inevitable. Vanguard expects stocks to produce higher long-term returns than bonds and cash precisely because they experience occasional downturns.

A review of corrections and bear markets suggests that patience and discipline are the best response to market turmoil. Vanguard's economic and investment outlook for 2016 underscores the potential benefits of a long-term perspective. Vanguard's outlook includes a range of projected outcomes for each asset class in the coming decade:

• Vanguard expects the central tendency for global stock market returns to be in the 6% to 8% range, as detailed in the outlook.
• Vanguard expects the central tendency for global bond returns to fall in the 2%–2.5% range. As the outlook explains, these muted expectations reflect an era of low interest rates and low inflation.

Vanguard's probabilistic forecasts acknowledge that the outcomes may be different, but investors have historically earned a risk premium for holding stocks through the inevitable setbacks. A balance between stocks and lower-risk assets such as bonds and cash can help moderate the impact of corrections and bear markets on a diversified portfolio.³

¹ As represented by the MSCI World Index from January 1, 1980 through December 31, 1987 and the MSCI AC World Index thereafter.
² Average annualized returns, January 1, 1928, to December 31, 2015: U.S. stocks = 9.72%; U.S. bonds = 5.41%; cash = 3.49%. Stocks are represented by S&P 500 Index. Bonds represented by Standard & Poor's High Grade Corporate Index from 1926 to 1968, the Citigroup High Grade Index from 1969 to 1972, the Lehman U.S. Long Credit Aa Index 1973 to 1975, and the Barclays Capital U.S. Aggregate Bond Index thereafter. Cash is represented by U.S. Treasury bills.
³ See, for example, Vanguard Group, The, 2014. Vanguard's principles for investing success. Valley Forge, Pa.: The Vanguard Group, p. 10.

Notes:

• IMPORTANT: The projections or other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM, derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2015. Results from the model may vary with each use and over time.
• The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
• The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time. The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk-return tradeoffs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered is the most effective way to use VCMM output. The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose "normality" on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths.
• All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Investments in bonds are subject to interest rate, credit, and inflation risk.
• Diversification does not ensure a profit or protect against a loss.
• Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.