Was This Bear Market Really So Different?

This post by Nate Hardcastle originally appeared on CBS' MoneyWatch.com.

(AP Photo/Seth Wenig)
One thing seemed clear during the darkest days of the recession and bear market: The rules of investing had changed. Investors of all stripes, from big guns at giant financial institutions to the guy chatting you up at the cocktail party, were trying to figure out how to operate in the new paradigm. Pimco CEO Mohamed El-Erian dubbed it "the New Normal," and GMO money manager Jeremy Grantham, who'd warned us all that this was coming, looked forward from here and saw "seven lean years."

But is it really different this time? From a big-picture perspective, the stock market to this point actually has behaved pretty much as it usually does in recessions: falling in anticipation of the economic downturn and rebounding hard before the economy starts growing again, with cyclical sectors leading the way down and back up. "With the benefit of hindsight, the market really did perform as you might have expected," says Todd Salamone, senior vice president of research for Schaeffer's Investment Research in Chicago. "The game hasn't changed."

The investing climate is surely different than it was pre-crash. But the fact that the market mostly has followed the usual script through the recession suggests that long-term investors shouldn't throw the old wisdom out the window. To the contrary, their recent experiences should help them use that wisdom. "Today's investors now have a once-in-a-generation bear market and recession under their belts," says Jim Stack, market historian and editor of the InvesTech Market Analyst. "They can draw on what they've learned to make better decisions in the future."

This Bear Looks Oddly Familiar

Stocks historically begin falling before a recession, as they did this time: The market peaked Oct. 9, 2007, two months before the official start of the recession, as determined by the National Bureau of Economic Research.

The S&P 500 then plunged 57 percent before rebounding 17 months later. Unless the market tanks again, this bear's duration will prove to be about average. Its size wasn't normal, of course: The drop was the market's worst since the early 1930s, and was more than double the S&P's average loss in bear markets since World War II.

That said, bears of similar magnitude have happened before - and recently. The bursting of the tech bubble knocked 49 percent off the S&P 500's value, while the 1970s oil shock led to a 48 percent decline. And those bears lasted much longer - twice as long, in the case of the 2000-2002 downturn. Of course, that assumes this one really is behind us. "It's understandable people would worry that things are different this time," says Sam Stovall, chief investment strategist for Standard & Poor's. "But mega-meltdowns are part of stock investing."

If there was anything unprecedented about this bear market, it was the degree of correlation between disparate asset classes. Every kind of stock got hammered, along with most commodities and most types of bonds. That's different from, say, 2000-2002, when small company stocks (other than tech companies) held up fairly well while the big, fast-growing stars of the '90s fell hard. Still, certain historical patterns held sway. Treasury bonds soared in value, while the types of stocks that fell the least (below) were the same ones that outperformed in previous bear markets:

Best-performing sectors
in this bear market
Average rank in previous
post-WWII bears
Consumer Staples -31% 1
Health care -40% 2
Utilities -46% 3
Energy -47% 4
Source: Sam Stovall; Standard & Poor's
Likewise, the worst-performing stocks were those in the cyclical financial, industrial, materials, and consumer discretionary sectors, which usually suffer prior to and early in recessions.

The upshot? While the recent bear was awful - the worst in 75 years - in many ways it acted as bears usually do.

A Recognizable Rebound

If the decline looked familiar, the rebound so far is spot on. The historical perspective: Stocks typically start recovering in the depths of recessions, when the economy looks brutal. The market ricochets off its lows, led by cyclical and speculative fare, as investors look ahead to better times - and the recession ends four to six months later.

The current recovery fits that pattern. As the first quarter drew to a close, unemployment, consumer confidence and GDP growth were the worst they'd been in more than a quarter-century. On March 9, The Chicago Sun-Times, among other publications, worried that "the fear factor is taking over the markets, the economy, and the public psyche."

The next day the market began one of the strongest rebounds in history, gaining about 58 percent through late September. Today economists generally agree that the recession is drawing to a close. On Sept. 15, six months after the stock market recovery started, Federal Reserve Chairman Ben Bernanke even stated that the recession "is very likely over."

Moreover, the top-performing sectors between March 9 and Sept. 24 were financials, industrials, materials, consumer discretionary, and technology, the same five sectors that led the way out of previous recessions. Also as usual, riskier fare led the way: Small caps gained 81 percent, microcaps jumped 89 percent, and emerging markets leapt 93 percent. "When you look at the rally that began in March, it really does match up with history," Schaeffer's Investment Research's Salamone says.

Those Who Learn from History...

The knowledge that things weren't so different this time should prove reassuring. It also may provide a measure of investing wisdom. Going forward, you should bear in mind the following principles:

1. Stocks often perform well when things look terrible
Don't let widespread fears about the market scare you out of stocks. To the contrary, the rebound since March illustrates that periods of investor skepticism can be the best times to hold equities - hence Warren Buffett's famous admonition to be greedy when others are fearful. "You want to hold stocks when people are worried, so they're not fully invested," Salamone says. "That means valuations are low and there's cash on the sidelines that can chase the market higher."

Easier said than done, of course, but Salamone is encouraged by the level of fear that persists in this market. He notes that institutional investors moved about a half-trillion dollars to cash during the decline, and haven't yet put it back into stocks. Stack points to a late August survey by the American Association of Individual Investors in which almost half of respondents said they were bearish on the market, while just 34 percent described themselves as bulls (the sentiment numbers tend to be fairly volatile, however). He sees the pessimism as a good sign. "You want to own stocks when no one else wants to touch them," he says.

2. The old rules still apply
Investors occasionally become convinced that the world has changed so much that investing fundamentals don't work anymore. They're almost always wrong.

Such "new era" thinking happens during both good and bad times: Investors cast aside the old rules during the panic of the bear market, just as they did during the euphoria of the tech and housing bubbles. "The four most dangerous words on Wall Street are 'this time it's different,'" says the InvesTech Market Analyst's Stack, echoing investing legend Sir John Templeton. "That applies to periods of extreme gloom as well as to periods of extreme optimism."

One big bear doesn't change the fact that stocks give you the best chance for growth over the long run. But it should serve as notice that stocks' occasional nosedives mean they don't always post the best returns, even over really long periods of time; investment researcher Rob Arnott has noted that bonds actually beat stocks during the 40 years through February 2009. For that reason it's important to ...

3. Remember risk when things are good
Managing the risk of losses is most important when the market and economy are humming along. Wait until conditions look bad, and you'll be too late. "Investors got so caught up in the six-year economic recovery and glowing corporate earnings that they forgot about risk," Stack says. "Then people bailed out in the depths of the bear market, after they had lost half their savings. They were faced with the decision of 'can I accept the risk of losing the little I have left?' And they decided the answer was no."

A better plan: If there's any money you absolutely can't afford to lose in the next 10 years, keep it in bonds and cash, no matter what the market has done lately. That advice may not be new - but in some ways, that's exactly the point.

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One Year Later: An Investor Who Predicted the Crash Tells Us What's Next
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What's Next for the Markets?
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