Quarterly Commentary

Q3 2018

US stocks registered their best quarterly result in almost five years. After recovering from February’s jarring setback, share prices continued to march upward, undeterred by higher interest rates and the escalating trade battle with China. Foreign stocks have been left behind – only a few overseas indexes are in the black so far this year.

It appears that US markets are leading a charmed existence. Though we cannot predict the future, it is appropriate to prepare for what might come next. The decisions that we make now determine not only how we do in the near-term but, importantly, how we will fare when the market does ultimately turn. History provides helpful perspective.

Bulls and Bears

In August, US stocks registered the longest uninterrupted advance of the post-war era. It began in March of 2009, a few months removed from the collapse of Lehman Brothers and the near meltdown of the broader global financial system. The tentative economic recovery made the risk of slipping back into recession seem very real. Almost ten years on, we are marveling at how US stocks have done so well for so long, and it is natural to wonder how much longer the good times can last.

The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents, the former thrusting its horns into the air and the latter swiping its paws downward. We are always in either a bull or a bear market, and learn of transitions after the fact, sometimes much later. The accepted definition of a bull market is one that rises over time until it is interrupted by a decline of at least 20%. When that determination is made, the peak dates the end of the bull and the start of the bear. This means the market has already registered a 20% decline when the bear’s existence is confirmed. In turn, we only learn of the bear’s demise when the market has risen 20% off its lows.

Bear markets are on average much steeper and shorter than bulls. There is no discernable relationship between the extent of bear markets and the size and age of the preceding bull market, and the inverse is also true. Interestingly, on four occasions (1976, 1990, 1998 and 2011), the S&P 500 slid 19% only to recover and reach a new high – no fun for sure, but not a bear market!

Historians inform us that there have been eleven bull episodes since World War II. Notable among them is the seven-year expansion following the war, fueled by the baby boom and foreign demand for American-made goods. In the case of the nine-year boom of the 1990’s, the rise of global trade and the development of the PC are credited. They ended very differently. The close of the post-war boom coincided with Cold War developments such as the launch of Sputnik and the brutal suppression of the Hungarian revolt while the expansion of the 1990’s ended as the Fed raised rates to quell the dotcom bubble.

We can identify three catalysts that distinguish current conditions:

  • 1. The near-zero interest rates engineered by the Fed encouraged capital to flow into just about any investment that promised a meaningful positive return.
  • 2. The availability of cheap debt facilitated massive corporate share buy-backs ($5 trillion of stock was repurchased by S&P constituents from 2009 through 2018, not far from the total value of the S&P back in 2009.) All else equal, reduced supply leads to higher share prices.
  • 3. Investors came to expect that the Fed would intervene to stem a serious decline in asset prices, emboldening them to take advantage of pullbacks and buy the dips.

    These favorable conditions appear to persist today. While interest rates are rising, they remain low relative to inflation. Overseas cash repatriated back to the US in the wake of last year’s tax bill is funding additional share repurchases. And, buying the dips has been working for so long that it has become ingrained investor behavior.

    There are some who see a recession as imminent – one that will finish off the bull market -- pointing to overtightening by the Fed and slowing overseas economies as possible catalysts. It’s true that recessions generally do coincide with bear markets, but that is not always the case. A striking example is the “Black Monday” stock market crash of 1987 that quickly came and went amidst benign economic conditions. Generally speaking, the things that lead to recessions are the same things that can change the direction of the stock market. Like bear markets, recessions aren’t “official” until they are well underway.

    Investor psychology may provide clues to the health of the bull market. The legendary Sir John Templeton famously observed that bull markets are “born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Certainly, this bull market emerged from a very dark place, and then spent years “climbing a wall of worry.” In retrospect, we are among the many who were serial worriers during this period, focusing more on what could have gone wrong than what was going right. That’s a sign of prudent investing, but when overdone, can become a recipe for missing out on the advance.

    We observe improving sentiment, a change from the skepticism that kept a lid on speculation throughout the first eight years of the market’s rise. The tax cuts of December 2017 generated noticeable excitement about stocks as we turned the page to a new year. The good feelings were clearly on pause during February’s 10% downdraft. Summer brought the return of a familiar pattern – consistent buying pressure manifested in a string of small gains. The S&P 500 rose in ten out of the third quarter’s thirteen weeks at an average rate of 0.88%. The three down weeks averaged a 0.61% decline.

    The latest University of Michigan consumer survey confirms the shift in sentiment – 63% of respondents expect share prices to be higher twelve months from now, up from a record low of 34% when the bull market began. The extreme divergence between the recent performance of growth and value stocks also reflects optimism that current trends will last far into the future.

    Using the Templeton framework, we think we are in the “mature on optimism” stage of this bull market. Euphoria is the final stage. The bubble of 2001 and the behavior of real estate investors preceding 2008 are classic examples. We don’t know how euphoria might appear on a broad scale, though we would agree that the ongoing cryptocurrency and cannabis manias qualify.


Whether sentiment provides a warning or not, we ought to be preparing for what may come next. History tells us that the average bear market drop is 25%, although the last two were larger, “once-a-generation” declines. Recoveries are often quick to take hold and on average take four years to retrace to prior market peaks. Financial planning should consider how investing and spending will respond to such a bear scenario.

Diversification is an important risk management tool. By owning a variety of assets in a portfolio, returns are smoothed and the risks of being over-exposed to the price fluctuations inherent in any one stock or asset class are minimized. However, there can be episodes during a bear market when diversification doesn’t seem to be doing its job. That’s because there is significantly more correlation among asset classes during bear markets compared to bull markets.

During bear markets, institutional and retail investors may be forced to sell whereas in normal times, selling is discretionary, generally undertaken for fundamental reasons like valuation. When the selling is urgent, prices can drop across the board in a hurry. In 2008, the rush for the door was exacerbated by the excessive use of leverage by hedge funds and other institutional investors. Those forced to sell will often trade to raise the most cash with the least damage. Ironically, large, liquid stocks may get hit the hardest in those moments when liquidity is the primary concern.

A combination of thoughtful financial planning, careful portfolio construction and emotional readiness can go a long way to protect investors from permanent financial damage during a bear market. These are key tenets of a sound plan:

  • 1. Diversification, however imperfect.
  • 2. Have cash (and short-term bonds) on hand to pay the bills and to buy when others are selling.
  • 3. Anticipate contagion, and don’t panic when it looks like the end of the world.
  • 4. Know that opportunity lurks in chaos.

We cannot say when a bear market might begin, how long it might last, and how deep it might be. But we can take steps to be prepared for whatever lies ahead.