“How low can you go?” 

When I hear this phrase, I think of the scene from Grease at the prom. When the song refrain comes on, Kenickie gets very low and is eventually kicked off the dance floor for vulgarity. Soon after that, Cha Cha DiGregorio steals Sandy’s spot with Danny to win the dance contest (big up to Olivia Newton-John, may she rest in peace). Sandy storms off while Danny stays, more focused on the short-term win than his long-term girlfriend.

This brings two questions to my mind: 

1. How low can markets go?

2. If you give up now in the short term, what could you give up in the long term?

Let’s consider and use history as a guide.

1. How low can they go? 

Historically, the stock market (S&P 500) has returned 9.6% per year for the last 50 years, and 7% per year since 1927 (including the Great Depression). We were, however, able to go even further back in time to the 1870s. A lot of regulation affecting financial markets has occurred since that time, but we thought it would be good historical context. 

From 1872 to now, there have been 16 bear markets (defined as down -20% or more) lasting an average of 27 months, ranging as short as two months (Feb/Mar 2020) to as long as 60 months (1930s). The worst of these was the crash before the Great Depression when the market lost 86% of its value. Assuming we are not headed for a depression, the next worst bear market was during the great financial crisis, when markets fell over -50%. 

The stock market is down -23% this year through Friday, September 30. I believe this bear market could end up being down a bit more — closer to the -30% mark.

2. If you give up now in the short term, what could you give up in the long term?

Well, bull markets have lasted longer than bear markets and on average, returns have been greater on the upside than when they fall. Since 1872, there were 19 bull markets lasting an average of 49 months, ranging as short as 17 months (after March 2020) and as long as 131 months (after 2008). The best of these was the bull market of the 90s, returning nearly 400%. 

Taking a bigger step back, as long as you have money you’d like to invest for the long term, selling your investments now could mean you’d have to get two decisions right — when to sell and when to buy back. It can be really hard to get both buy and sell decisions perfectly right. That’s why common advice is to stay invested if you can, and take advantage of a bear market by adding a little over time — aka “phasing in.” By adding a little at a time, it can actually make it easier to get invested, and stay there. 

It can be hard to get the two decisions right because of the emotion involved. Though past market returns don’t predict the future, historically, the best time to invest has been when it feels the worst — when it's full of fear. This is because the market is a forward discounting mechanism. It’s always saying “next.” So by the time the economy feels good, that information has already been assumed into the market. In fact, when we looked at the last nine recessions, in most cases, the market bottomed around six months before the recession ended. In addition, the markets bottomed well before unemployment started to get better. 

You might be wondering if there are any signals to know when the market might turn up. In my experience, some signs can come from a combination of valuations and fear. Valuations should start to be low relative to history. In particular, because one input to valuations is earnings, earnings expectations often need to broadly come down (I think this still needs to happen in this downturn). They should come down to a point that even the slightest improvement can be a happy surprise to the market. The other signal I’ve considered is fear. Is market news a considerable downer? Does it feel like bad news is the norm? Or even worse, is fear palpable like there is too much unknown about what comes next? If so, and if you have investable funds and a longer time horizon, that may be a signal to start phasing in (see above), but always be prepared for a bumpy ride. 

So the next question is — where might the opportunities lie? The answer really depends on you, your needs, your time horizon, and other factors. That being said, after the last few bear markets, there have been commonalities among what has done well. Often we saw what did worst in the bear market eventually turned around to do the best in the following strong market. However, cyclicals and small caps have typically performed the best during the onset of a bull market. It kind of makes sense as both rely on a recovering economy the most. When we look across the spectrum today, that might mean Financials and Energy (continued), but it needs to be right for you. And like I said earlier, I am not convinced we are close to the end of the bear market yet. 

So the markets can go pretty low, but if you can, when it comes to your portfolio, I think it’s better to focus on Sandy for the long term, and not get distracted by Cha Cha. 

Sources: US stock market data from 1871 to 1927 from Shiller, which was used in his book Irrational Exuberance and was taken from Standard and Poor's Statistical Service Security Price Index Record, various issues, from Tables titled "Monthly Stock Price Indexes — Long Term." This monthly data represents an approximate average of daily close data in a month (please see here for more information). For data from 1927 to 2022, Yahoo! Finance S&P 500 Index monthly close data, Bureau of Labor Statistics, Bloomberg.