Anatomy of a Bear Market: How to Position Your Portfolio in the Event of a Recession?

 

A bear market is most commonly defined as a decline of a particular market from peak to trough of more than 20 percent. In this blog, we will focus on the behavior of the American S&P 500 index, which is generally considered the best measure of large-cap U.S. stocks and serves as a basis for a wide range of investment products. Although the 20 percent decline threshold is arbitrary, crossing this level has historically been an important dividing line between painful but short-lived corrections and corrections where recovery lasted several years, writes Jure Borovac, fund manager at Intercapital.

 

It is important to note that this is a normal part of investing and that every investor will almost certainly experience several such periods throughout their working years and retirement.

 

At a level of -20.3 percent, this year’s correction is approaching levels that are typically only present around recession periods. During the 12 recessions since 1950, the median decline of the S&P 500 index was around 27 percent.

 

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Graph 1: Size of S&P 500 10% + corrections from 1950 to present

Source: Bloomberg, InterCapital Asset Management

 

Additionally, corrections outside of recessions typically lasted about three months, while the current one is entering its 7th month, bringing it closer to durations historically seen during recessionary periods (Graph 2). When observing the 12 recessionary periods since 1950, the stock market began to price in the recession on average seven months before the official start. In all cases, except one, the market peaked before the recession began and bottomed before the end of the recession. The recession of the 2000s is the only one that did not follow this pattern. In that case, the stock market continued to decline for another 8 months after the end of the recession, reaching its bottom only 30 months after the start of the decline.

 

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Graph 2: Duration of S&P 500 10%+ corrections from 1950 to present

Source: Bloomberg, InterCapital Asset Management

 

 

If we delve a little deeper into the index, we can see which sectors have performed better during such periods. The next graph shows the median returns of individual sectors considering the last five recessionary periods. We have already concluded that markets generally price in the recession before the official start of the recession itself, so it is not surprising that the best sectors before the onset of recessions are generally defensive in nature, such as the sectors of non-discretionary consumption, healthcare, and utilities.

 

Stocks in these sectors are characterized by stable earnings and dividends regardless of the current state of the overall market, making them stable across different phases of the business cycle. Looking at the 12 months after the start of a recession, defensive sectors still appear to be a better option, but the situation is a bit unclear as cyclical stocks, which are more dependent on economic recovery, tend to perform better towards the end of the recession, including sectors such as discretionary consumption, finance, and IT.

 

Thus, recessions do not typically impact all sectors equally, and successful active management can make a significant difference in performance compared to the average market return.

 

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Graph 3: Median sector returns during the period around 5 recessions since 1981 for the S&P 500 index

Source: Bloomberg, InterCapital Asset Management

 

Currently, the median analyst projection for the probability of a recession in the U.S. over the next 12 months is at 33 percent. As we could see in the previous graphs, the stock market is currently in a dilemma regarding the further outcome. Additionally, events over the past two years have led to government bonds such as U.S. and German bonds once again providing more attractive yield levels.

 

Over the past two decades, the correlation between stocks and bonds has generally been negative, allowing investors to rely on bond positions as protection against stock declines during recessionary periods. However, in the past two years, this relationship has weakened, and the correlation has entered positive territory, with increased uncertainty around inflation being the main reason.

 

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Graph 4: 1-year correlation between the S&P 500 index and 10-year U.S. Treasuries based on monthly returns

Source: Bloomberg, InterCapital Asset Management

 

Every bear market is different from the previous one, but one constant is present: there are always dislocations that can provide opportunities for increased returns in the future. A potential recession would likely lead to further declines in the stock market, but in return, the correlation between stocks and bonds could revert to negative levels. This would provide bond investors with protection against stock declines, and in the event that a recession does not occur, bonds should historically continue to provide attractive yields, especially now that yields have risen sharply (i.e., bond prices have fallen).

 

Although the possibility of a recession is assigned a certain probability, most expectations remain more optimistic than that scenario. High profit margins and limited leverage mitigate risks for companies, and personal consumption levels continue to show solid figures. Additionally, the magnitude of the current stock market decline provides an opportunity for higher returns in the future should a recession not materialize.

 

For the upcoming period, most analysts still expect real economic growth, but risks are somewhat higher than at the beginning of the year.