March 18, 2020

Well, there you have it! Just after I wrote a post two weeks ago pointing out we hadn’t even reached a Bear Market yet, all major U.S. indices, including the S&P 500 and the Nasdaq Composite tanked and fell into Bear Market territory last week and even touched the -30% mark after the precipitous fall on Monday.

So, it’s a Bear Market now, all right! But not all Bear Markets are created equal. Which begs the question…

What KIND of bear will this be?

A little cuddly Panda Bear like in the picture above? Or the fearsome Grizzly Bear? Here are some of my thoughts and reflections on the Bear Market…

Bear Markets vs. Corrections

Remember the chart from two weeks ago? I updated it comparing the current equity meltdown with the previous five corrections (all post-global financial crisis), see below. This goes up to yesterday’s close, 3/17/2020. And now it does indeed look quite a bit more menacing than the other 5 events:

And, for comparison, here we have the last two bear markets: one started in 2000 and in 2007, respectively, in the chart below. This is starting at the peak level, measured in Total Return (dividends reinvested) and for the 2000 and 2007 bear market starts I plot the return both in nominal and real inflation-adjusted terms. The current bear market is in nominal terms only because it’s still too short and the real vs. nominal wouldn’t make a difference yet!

In any case, while the 2020 bear market is nowhere near as deep as the previous two (yet), it’s surely much swifter than the other two! During the other two events, it took more than a year to reach the -29% (Monday low). So, this Bear isn’t messing around here, folks! They say “Markets Take the Stairs up and the Elevator Down.” I beg to differ: the last four weeks felt like the cable ripped and we fell down the elevator shaft!

One other “fun” fact about bear markets: the year-2000 Bear Market hadn’t even recovered in real terms before the next Bear Market hit. That recovery took almost 13 years (4620 days). But it was hard to squeeze that all into one chart.

Thus, I like to reiterate one important point I made many times before, for example in my “Who’s Afraid of a Bear Market?” post last year: There’s a lot of bad and inaccurate advice out there, such as

“Nothing to worry about if a bear market hits, it will only last a year or two.”

That crucially depends on what you worry about. Notice, the length of the Bear Market is only the time peak to trough. If you’re worried about Sequence Risk you gotta be worried for as long as the market is below the peak. And that’s for CPI-adjusted returns! That can take a lot longer than one to two years!

Summary so far: Bear Markets tend to take a lot longer to recover than corrections. Instead of weeks to months, we’re now talking about years – potentially even a decade or more! Ouch!

So, do I expect a Bear Market as bad as in 2000 or 2007? Not necessarily. Historically, there’s a huge range of recovery times for Bear Markets. Again, recall my post from last year (“Who’s Afraid of a Bear Market?“) and the following pattern emerges; it all depends on whether we have a recession and if so how bad the recession may be:

A Bear Market with no recession at all (e.g. 1987): That’s going to recover relatively quickly in a matter of roughly 2 years. And again, with recovery, I mean going from peak to trough and back to the peak, in real, CPI-adjusted terms, e.g., 23 months even in the 1987 best-case scenario. A Bear Market during/around a mild recession (e.g. 1968): Definitely a scary time for investors, especially retirees, but this kind of bear market is normally too shallow and too short to pose much Sequence Risk. Expect a recovery in 2-5 years. A Bear Markets during deep and prolonged recessions (e.g., twice during the Great Depression, 1970s, and the 2000-2013 period): A bear market that is deep enough and takes long enough to recover: 5+ years and in some cases even 10+ years!!! That will certainly pose a challenge to retirees due to Sequence Risk !

So, what kind of Bear Market will this be? Simple: We’d have to gauge how bad a hit the economy will take. No impact at all, a small hit or a major, prolonged recession. That brings us to the next point…

The macroeconomic conditions still look good. But for how long???

If you remember, I put together a “poor-mans version” of my macro market timing model. Specifically, I like to look at three indicators:

The yield curve slope (10-year minus 2-year Treasury Yield): There were obviously some rumblings in the yield curve signal last year . The 10-year vs. 2-year slope very briefly inverted in 2019. But the inversion was very shallow and short-lived. So, I never really considered it a certifiable yield curve inversion. I also don’t quite see the connection between the 2019 yield curve predicting a 2020 recession when COVID-19 wasn’t even known back in 2019. Currently, the spread between the short and long end of the curve is solidly positive (0.36% for the 2Y vs. 0.73% for the 10Y as of 3/16), indicating that financial markets don’t believe the Federal Reserve is too hawkish. The weekly unemployment claims, released every Thursday: Unemployment claims come out weekly and as of the last release, Thursday last week, they still look rock-solid. I’d monitor this very closely and watch for a spike in unemployment claims to 300k+. This could happen really quickly! The ISM Purchasing Manager’s Index (ISM-PMI), released (normally) on the first business day of the month: The PMI had shown some weakness in late 2019 but then recovered again to 50.1 as of February. The only problem here: that reading for February, released on March 2, covers a period before there could have been much panic among those purchasing managers. We’d have to wait until April 1 to get a new reading on this indicator and even then it’s not certain all the macroeconomic impact on the business world has already been factored in.

How do I interpret this? Going forward there are three possible scenarios:

Since the macro indicators didn’t move yet, the drop in the stock market will be temporary. There’s only a mild slowdown, no recession. It’s another a mid-cycle slowdown. This bear market came about very quickly and it will also recover very quickly. Basically a 1987-repeat. It’s too early! There will be a noticeable impact on the macroeconomy and it will show up in the data only in April and May or later. And then we’ll have enough data to spot signs of a mild recession. But the stock market will be in the basement by then and the whole macro timing is useless! … or even a full-blown deep recession later this year.

If you ask me, I’d suspect we’ll be in case 2. It’s just a matter of time until noticeable signs of a slowdown will show up in the macro data releases. If travel is restricted, events are canceled, people stop going to restaurants and bars, production lines shut down, businesses furlough workers, etc. it must have an impact on the economy. It will likely result in (at least) a mild recession.

Will this potential recession reach the severity of the Great Recession or even the Great Depression? I don’t see that yet. True, one prominent faster-moving financial indicator, the VIX (“Fear Index”) is indeed as high as during the Global Financial Crisis. It went above 80 on Monday! That’s what seven trading days in a row with 100+ point moves in the S&P and 1,000+ point moves in the Dow Jones do for you. And I’ve sold S&P 500 put options with an implied volatility of more than 170% on Monday! Crazy stuff!!!

But other indicators are not yet screaming crisis. High-yield spreads are elevated, but nowhere near what we observed in 2007-2009. Actually, we’re still more in line with the 2011 and 2016 market scares that didn’t even become bear markets.

Another measure of financial market stress is the “TED-spread”, i.e., the spread between the 3-month LIBOR (interbank lending) rate and the 3-month U.S. Treasury Bills. It rose a little bit but is nowhere near the levels we observed in 2007-2009. We haven’t even reached the levels of some of the post-GFC stock market corrections.

These are the kind of real-time daily indicators we’d have to watch while waiting for the macro data to trickle in over the next few months. Expect more uncertainty and volatility!

So, I’m definitely quite a bit more uneasy about the situation than two weeks ago. And it makes perfect sense to me now. If I look back at all the corrections I plotted in my chart above, they had very little potential to do any real harm to the economy. If you had asked folks in the street in August 2011 “Are you worried about the U.S. bond downgrade?” most people would have asked you back, “What’s a bond downgrade?” Same with the August 2015 Chinese devaluation. But the Corona virus is different. This is something that directly impacts a large number of people.

Right now, it’s impossible to gauge the damage this will do to the economy. Just to give you an example of how easy it is to underestimate the potential damage, back in 2007 a lot of really smart people argued that the subprime market blowup will be contained. “Yeah, nothing to worry about: the subprime market is small enough, even under pessimistic assumptions, the losses will be a few $100b, which is worth a few percentage points of the S&P 500 market valuation.” Nobody expected the stock market to drop by 56% and millions of people losing their homes and jobs. And potentially now again, for every Wuhan Virus death, there will be dozens of sick people and hundreds of scared people staying at home and not participating in the economy as workers, business leaders or consumers. So, even if casualties stay well below the worst-case scenarios, this virus has the potential to do serious harm to the economy and thus the stock market.

And I don’t even want to think about the worst-case scenario, but if you’re interested, see here for a thought-provoking discussion started by my blogging buddy “Gasem”. Also, make sure you check out his blog MDonFIRE.com for some more info.

What now if you’re still saving for retirement?

What does this all mean for investors? If you’re familiar with my blog, you’ll know that I like to differentiate the impact of market volatility by where you are in your (financial) life. Most people in the FIRE community and also a lot of readers here are not yet retired. So let’s start with that case. How much damage can a bear market do when you’re still saving for retirement? Well, that depends on how far along you are with your retirement savings plan. If you had just recently started out with $2,000 in your 401(k) and you suffered a 30% loss, who cares? That $600 is easy to replace. In contrast, If you were at $2,000,000 and right before early retirement, a $600,000 loss will take some time to replenish. How much time? Instead of going through endless simulations, let’s just go through some simple rule-of-thumb calculations…

Assume you pursue FIRE with a 50% savings rate. You plan to accumulate 25x your annual consumption (a very crude rule of thumb , I know!) and you also save 1x your annual consumption (=50% savings rate)

, I know!) and you also save 1x your annual consumption (=50% savings rate) You assume a 5% (real) rate of return and monthly contributions (0.0833x annual consumption per month). Same as in the MMM Simple Math post .

You can really easily calculate how many months you’d expect it would take to reach FIRE. For example, if you already have 6x your annual consumption in your FIRE stash you’d use Excel and compute:

=NPER(0.004074124,0.083333,6,-25,1)

i.e., with the 5 inputs:

0.004074124 = the monthly real return =1.05^(1/12)-1

0.083333 = the monthly contribution (=1/12)

6 = the initial stash

-25 = (-1) times the final value target

1 = indicating we invest money at the beginning of the month (set to 0 if you assume the contributions occur at the end of the month)

This yields 132.8 months, which I round up to 133 months.

Now let’s check what happens if we apply a 1-time “haircut” to the portfolio; the results are in the table below. Each row corresponds to an initial portfolio value (as multiples of the annual consumption target). The columns are for the base case of that initial capital (i.e., no bear market) and then a one-time market drop between 5% and 50%, in 5% steps. For example, if you start with 6x initial assets, it will take you 133 months to reach 25x annual consumption, as we computed above. A one-time drop by 25% would increase your projected retirement date to 148 months, 15 months longer. Not surprisingly, even a steep bear market prolongs your FIRE savings only by a few months if you’re still starting out on your path to FIRE!

But if you were right before reaching FIRE, say 20x or more and the portfolio drops by 25%, you’re looking at about 3 extra years. Again, this is not written in stone because the market could recover much faster than 5% p.a., but some folks in the FIRE community might feel a bit deflated when they update their projected retirement date. Don’t be! Stay the course, keep investing and you’ll still retire way before you’d have ever imagined before finding the FIRE community!

What if you’re already retired?

Great question! I’m still working on this section. So, stay tuned for this portion as part of the Safe Withdrawal Series! Hopefully next week! 🙂

PS: if you find the title picture offensive…

I know, I know, I am being a little bit politically incorrect. Get it? Wuhan Virus? A Panda Bear in the title picture? How culturally insensitive of me. If even the mighty NBA has to kowtow to the Chinese Communists then who am I as a little one-man show in the blogging world? So, if I receive more than 1,000 tweets/retweets with complaints about my post I will gladly change the title picture to something completely, totally non-offensive. Like this one with an almost equally cuddly bear, see below. Hard to imagine that the Communist Party would have any problem with Winnie The Pooh, right?

And again, sorry if people are offended when I even associate that virus with China. Because, according to this really smart fellow here, Zhao Lijian, the Wuhan Virus isn’t from Wuhan at all, but it was smuggled into China by Americans. Just like German Measles and the Marburg Virus are actually from Kansas! They were just smuggled to Germany to make Germans look bad. Everybody knows that! When will the shaming of Germans finally stop? I mean, the French get their French Toast, the Danish also get a sweet dessert. The Polish and Italians both get their tasty sausages. And the Germans? We get stuck with highly infectious diseases. And cockroaches! It’s time to find less offensive names! And while you’re at it, please also rename the Norway rat! Because we always, always, want to be really culturally sensitive out there!

Hope you enjoyed today’s post! Please leave your comments and suggestions below!

Picture credits for Panda and Winnie: Pixabay.com

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