Volatility is King in a Bear Market

From the start of 2010 to the end of 2019, we never (officially) dipped into a bear market. It was the first-such decade in American history. Now, a whole generation of investors is learning firsthand what the bear is all about. The biggest lesson so far: Things happen fast.

Last Monday, U.S. stocks fell a whopping 7.6%. Tuesday and Wednesday followed up with a 4.9% rally and decline, respectively, before Thursday’s selloff turned into the worst since 1987. Friday’s subsequent 9.3% gain was the largest since 2008.

After more than 20,000 days of trading since S&P 500 data begins in 1927, only 289, or 1.26% of them, have recorded price changes of more than 4%. It happened 5 times last week alone. If daily returns were randomly distributed, the odds of such an event would be 0.00000003%, or roughly one in 3 billion. But returns aren’t randomly distributed.

Welcome to a bear market, where volatility is king.

It’s common knowledge that stocks in the U.S. have returned, on average, about 10% per year. When gains or losses like those of the last few trading days outpace an entire year’s worth of returns, it seems clear that capturing the largest increases, or missing largest losses, can have an out-sized impact on financial plans. In fact, I’ll bet you’ve seen some version of the following:

Or perhaps the opposing scenario, here:

Both are factually true. And both are equally misleading. In the case of the former example, the presenter is usually trying to convince readers of the importance of never selling. The market’s moves can’t be timed, so one MUST stay invested or they’ll never achieve their financial goals. But oddly enough, the example designed to discourage any attempt at market timing assumes perfect timing – or more accurately, perfectly awful timing. It misses every one of the best days, but suffers through each of the worst.

The latter table promises spectacular outperformance if one can simply avoid the major declines. But just as before, the example assumes a foresight perfect enough to miss all of the worst days, but none of the best.

In reality, the best days and the worst days come hand-in-hand. And more often than not, they come in bear markets.

Since the 1920s, stocks have spent about one quarter of their time in bear markets:

Source: Mader Shannon Wealth Management Inc.

Yet even though bear markets account for only 25% of all trading days, they’re home to 69% of the most volatile days. In other words, a +/- 4% move in stocks is 6.8x more likely to occur during a bear market than in a bull.

And the large days are more likely to be negative. Since 1927, about 52% of all trading days resulted in positive returns for investors, but for absolute changes of more than 4%, negative days were more common, at 52%. And during bear markets, negative returns held a larger edge, accounting for nearly 60% of all 4% moves. It seems a bit obvious to say the majority of the worst days occur during a bear market, but what about the other side of the coin?

Once a bottom is established, large up days tend to come in bunches – of all the biggest up days, more than 10% have come in the 2 weeks after a bear market trough (or, if you will, at the start of a new bull market). But don’t be fooled. The majority of all the biggest up days, fully 59% of them, actually happen before a bear market troughs. They occur in the meat of the bear market, where the largest negative days outweigh them.

That’s why catching a falling knife is so difficult: the bottom is marked by large rallies, but so is the entire bear market decline. Buying at the bottom of a bear market may be a great way to achieve out-sized returns, but it’s easier said than done.

You probably won’t remember any stats from this post, but if there’s one thing to remember, it’s this: Volatility is a characteristic of bear markets.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

Comments are closed.

Up ↑