How to prepare for the next bear market [UBS guidebook]

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Introduction

Are we in a bear market? Not yet, in our view. While 2018 saw a 19.8% peak-to-trough drop in US large-cap stocks (S&P 500), we consider this a run-of-the-mill bull market correction, not the beginning of a bear market. We expect the current economic expansion and equity bull market to continue for some time but, even so, you should not wait until the next downturn is imminent to take commonsense steps to plan for a bear market.

By studying bear markets closely, you will learn that they aren’t as dangerous as they seem. Cutting through the many misconceptions, our goal is to help you lay the foundation for protecting yourself against market downturns. In three parts below, we explain why bear markets need not threaten financial success, and how they can be an opportunity to improve long-term returns for those who are prepared.

Bear market characteristics

We define a bear market as an episode where US large-cap stocks fall by at least 20% from peak to trough. But rather than focus only on the peak-to-trough drop time period, or the drawdown period, we also stress the importance of considering how long it takes for stocks to register another all-time high. After all, the time under water—when markets are struggling to recover from their losses—represents the period in which you may be forced to lock in losses.

A big percentage change for one asset class may represent a relatively minor move for another. So while we use US large-cap stocks as the basis for defining bear markets, this is only for clarity. Well-diversified portfolios—which include global stocks as well as fixed income—are structurally designed to protect against the most painful parts of equity bear markets.

With this in mind, let’s look at US large-cap stock statistics for equity bear markets since World War II in order to evaluate what market cycles look like using our framework.

Peak year

1946

1961

1968

1972

1987

2000

2007

Average

Length of prior bull market*

169

184

78

31

157

155

62

119

Time between market cycles**

204

190

84

50

179

158

87

136

Peak

31/05/1946

31/12/1961

30/11/1968

31/12/1972

31/08/1987

31/08/2000

31/10/2007

Trough

30/11/1946

30/06/1962

30/06/1970

30/09/1974

30/11/1987

30/09/2002

28/02/2009

Recovery date

31/10/1949

30/04/1963

31/03/1971

30/06/1976

31/05/1989

31/10/2006

31/03/2012

Max drawdown

–21.8%

–22.3%

–29.4%

–42.6%

–29.6%

–44.7%

–51.0%

–34.5%

Time to full recovery (new all-time high)

41

16

28

42

21

74

53

39

Drawdown time

6

6

19

21

3

25

16

14

Recovery time

35

10

9

21

18

49

37

26

Months of prior gains ‘erased’

15

36

66

118

18

64

141

65

When assessing bear market risk, it’s important to cut through the taboo that surrounds them. Yes, bear markets are painful. But they are also rare, and over relatively quickly. Since 1945, stocks have spent about two-thirds of the time at or within 10% of an all-time high. In this light, it’s clear that markets behave more like a runaway train than a cycle or clock when viewed over the long term. As an investor, your job is to try to keep up with the train, which rarely stops and never truly goes backwards. This context is noteworthy as you ask yourself how much long-term growth you’re willing to forfeit in order to improve your comfort level during the painful-but-rare pauses.

Before the bear shows up

Unfortunately, history tells us that the quest for the perfect hedge may be a wild goose chase. No matter how well-intended or designed, the strategies that provide the most potent protection against equity downside risk also tend to be the most costly as they sacrifice long-term growth potential.

We typically recommend prioritizing cost-effective protection before moving on to less-reliable or costlier hedging strategies. Below are four “damage mitigation” strategies, in declining order of efficiency.

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