Bear markets and recessions are not identical, but investor responses should be.  Staying the course with multi-factor diversification through bears and recessions is our suggested course of action based on a review of the evidence.  This thought capsule is a follow-on to our analysis of recessions and factor performance.

By Andrew L. Berkin, Ph.D., Head of Research, and Geoffrey G. Crumrine, Head of Client Service and Marketing

In the early spring of 2020, investors found themselves in a situation they hadn’t experienced for a decade: Confronting a bear market. Global stock markets tumbled in February and March over concerns about the economic impact of the coronavirus pandemic. The S&P 500 Index, which had reached a high on February 19, ultimately fell more than 33% from its peak until bottoming out on March 23—putting the index well into bear territory.

Subsequent economic stimulus efforts from the U.S. government helped improve investor sentiment and stocks began to recover over the following months. Those gains drove the S&P 500 back to a new record high in late August 2020, signaling the end of the bear market. Despite the apparent short duration of the latest bear, stocks remain volatile and many investors are still wary about the future. However, bull and bear market cycles are to be expected when pursuing a long-term investing strategy. Unfortunately, we can’t predict when bear markets will occur or how long they will last, and we can’t control the external factors that help dictate broad market movements. But we can examine historical data to understand how portfolios have performed during past bear markets.

Following up on our recent analysis of recessions and factor performance, we wanted to take a similar deep dive into the phenomenon of bear markets and the performance of the underlying factors that shape stock returns. Bridgeway’s previous research into past recessions uncovered data that emphasizes the fact that it’s risky to try to time both the economic cycle and the market’s performance. Individual factors don’t move in lockstep during recessions. It’s not surprising, then, that we observe similar patterns in the historical record for factor performance before, during and after bear markets. But just as recessions and bear markets are distinct events, factor performance isn’t identical during each.

A Broad Look at Bear Markets Throughout History

Markets typically are considered to be in bear territory when they have fallen by 20% from their highs. Since 1926 through February 2020, we’ve identified eight bear markets according to this 20% peak-to-trough decline convention (not including the most recent February-March downturn)¹.

The chart below illustrates this history. The line shows the growth of $1 invested in the broad stock market, with red sections representing bear markets and blue sections representing bull markets. Overlaid on this graph, we’ve also plotted economic recessions, represented by grey bars.

Sources: Ken French Data Library, NBER, and Bridgeway calculations

First, we note that one dollar invested in the stock market in July of 1926 would have grown to more than $7,500 by the start of 2020. Despite recessions and bear markets, many stocks have been an excellent investment over the long term. In fact, we could replace the word “despite” in the previous sentence with the phrase “because of.” Stocks are a risky investment, but this risk comes with the potential for the higher rates of return that reward investors.

Interestingly, we also see that bear markets and recessions often—but not always—overlap. Since 1926, the market experienced 15 recessions and 8 bear markets. Even when recessions and bear markets coincide, they don’t share exact start and end dates. And sometimes, we have recessions without bear markets or bear markets without recessions. One example is the 1987 bear market, which includes the October 19 market crash often referred to as Black Monday. Although a painful bear market, it did not have a corresponding recession attached.

Factor Performance and Bear Markets

While the data above displays how the overall market has performed since 1926, we also analyzed how individual factors performed before, during, and after bear markets. Table #1, below, shows average factor returns for Fama-French factors and momentum relative to market environment.

Table #1: 8 Bear Markets Going Back to June 1926

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

	Market premium (Mkt-RF)	Small size (SMB)	Value (HML)	Momentum (MOM)	Profitability (RMW)	Conservative investments (CMA)
All Months	0.67	0.19	0.35	0.66	0.26	0.27
Bull Markets	1.27	0.27	0.29	0.52	0.14	0.12
Bear Markets	-3.70	-0.34	0.76	1.64	1.10	1.32
12M Pre Bear Mkt	1.76	0.14	-0.03	1.44	-0.24	0.21
12M After Bear Mkt	3.25	1.02	1.16	-2.06	-0.24	0.26

As we see in the second row, all factors did well in the more prevalent bull market months, although the company financial health related metrics of RMW and CMA were weaker than typical. Row three shows that, as expected, the market factor (Mkt-RF) was strongly negative during bear markets but recovered especially well in the 12 months following. Stocks tend to rebound dramatically after a bear market. There is an old saying that no one rings a bell at the top or the bottom of the market. Timing the markets is difficult, and as the recovery from bear markets shows, missing out can be quite costly.

The performance of other factors is quite different depending on the period. Small stocks suffered during the risk-averse times of bear markets but performed strongly in the recovery. In contrast, value stocks held up quite well during bear markets. Noting that value is negative on average in the 12 months beforehand provides some insight into this behavior. The market environment before the onset of a bear is often characterized by exuberance, with growth-led rallies. However, value has come back into favor during the ensuing downturn and subsequent recovery. The aftermath of the late 1990’s technology bubble is a well-known example of this pattern.

Perhaps somewhat surprising is the behavior of momentum, which generally holds up quite well during bear markets but fails miserably afterwards. This pattern was first described by Cooper, Guillen and Hamid.² When markets bounce back, those stocks that have lost the most often lead the recovery, and momentum suffers. (For more in-depth analysis, see the Bridgeway white paper “When and Why Does Momentum Work – and not Work?” by Andrew L. Berkin.)

When we compare these returns to our previous analysis of factor returns during recessions, we see many similarities—but also important differences. For example, factors related to company financial health (RMW and CMA) perform strongly in both recessions and bear markets, as investors favor higher quality companies in both environments. In fact, the returns for RMW and CMA are even stronger in bear markets than they are in recessions. However, the performance of these two factors diverges in the aftermath of the different events. The profitability factor RMW, which has stronger-than-average returns in the 12 months following recessions, is actually negative in the 12 months after bear markets.

Another difference is the relative effectiveness of the value factor during and after bear markets. Value’s returns are reduced (but still slightly positive) during recessions, and its outperformance in the 12-months following not quite as strong as the substantial turnaround we see following a bear market.

Critically, we see that factors don’t move in lockstep around these two distinct market and economic events. And in both cases, we see dramatic reversals in leading and lagging factors before, during and after both recessions and bear markets. As we said earlier, trying to time these shifts is difficult, which is why we emphasize the importance of maintaining diversification across multiple factors.

Case Study: Bear Market of 2000-2002

Moving down from the 30,000-foot view, let’s examine the bear market of 2000-2002. Previously, we analyzed the recession of 2001 to show that factor performance during that event did not line up with long-term historical averages. For this reason, we thought it would be interesting to look at a bear market that occurred around the same time.

The recession of 2001 started in March and lasted for 8 months, ending in October of the same year. In contrast, the bear market predated the recession (beginning in September 2000) and ran for 25 months (ending in September 2002). It was the second-longest bear market after the one that coincided with the Great Depression.

Table #2: Bear Market of Sept 2000-Sept 2002 (25 months)

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

	Market premium (Mkt-RF)	Small size (SMB)	Value (HML)	Momentum (MOM)	Profitability (RMW)	Conservative investments (CMA)
During Bear Market	-2.51	0.73	2.40	1.51	3.00	1.97
12 M Pre Bear Mkt	1.31	1.48	-1.30	4.09	-1.55	0.04
12 M Post Bear Mkt	1.99	1.45	-0.54	-2.47	-1.70	1.04

Source: Ken French Data Library and Bridgeway calculations

The data for the bear market of 2000-2002 offers a good example of the risks of attempting to time a bear market and tactically adjust factor exposure. While value’s positive performance on average during bear markets hasn’t been as strong as the returns for momentum, profitability, and conservative investments, the bear market of 2000-2002 saw value delivering substantial gains. Recall that growth stocks had been dominant in the tech bubble of the late 1990s and the first quarter of 2000. For the 12 months before this particular bear market, value lagged by an average of 1.30% monthly. The collapse of formerly high-flying growth stocks not only helped usher in the bear market and subsequent recession, but also set the stage for historically discounted and beaten down value stocks to recover strongly. Many investors who had abandoned value stocks during the run-up of tech stocks likely missed out on a substantial portion of value’s gains.

Key Takeaways

As noted earlier, we can’t predict whether a modest drop in stocks presages a dramatic slide into bear market territory. Likewise, we never know if a bounce from market lows will lead to a full recovery or is merely a temporary rally. Examining how factors have performed historically around bear markets is instructive, but also shouldn’t be taken as a prescription for portfolio changes. Remember, the factor returns shown in Table #1 are averages across multiple bear markets, and as we saw when examining the bear market of 2000-2002, they don’t hold every time.

For those reasons, investors should avoid making dramatic changes to their portfolios based on where they believe we are in the market cycle—just as we cautioned against making changes around recessions. Remember that factors have worked over long periods. They don’t always deliver positive returns, but when one is lagging others often provide a positive return cushion. What’s more, those lagging factors have rebounded in the past. For example, small size and value underperformed large growth in the run-up to the most recent bear market and continue to lag. But historical data showing that small size and value have recovered strongly after past bear markets gives us confidence that they will again — we just can’t predict when the turn will happen and how robust the recovery will be.

Considering this evidence, we believe building a well-diversified portfolio with exposure to multiple factors and rebalancing to return to those targets when a factor or asset class moves out of line with your chosen allocation target. That strategy may help investors avoid the costs associated with excessive trading and the substantial risk of missing out on gains by getting the timing wrong as the markets move through their inevitable cycle of bulls and bears.

Examining factor returns from past recessions reinforces the importance of diversification and the dangers of market timing

It’s official. On June 8, 2020, the National Bureau of Economic Research (NBER) declared that the United States entered a recession in February of this year. Somewhat anomalously, on that same day the S&P 500 gained 1.21% to move back into positive territory for 2020. After falling roughly 33% from its high to usher in a bear market, the index rallied nearly 45% from its lows on March 23 through the date of NBER’s recession announcement.

So, while it is bad times for the economy, the stock market is regaining its former euphoria. It’s understandable if investors are wondering what this means for stocks going forward, and for the factors that shape their returns. While we can’t predict the future, we can examine how these factors have performed during past recessions—and what happened before and after those events.

Bridgeway’s research into past recessions uncovered data that reminds investors that it’s risky to try to time both the economic cycle and market’s performance. Individual factors don’t move in lockstep during recessions. Some, like momentum, hold up fairly well. Others, like small size and value, lag. However, our research on past recessions also shows that factor performance can turn around quickly, with small size and value enjoying strong returns in post-recessionary periods. We believe this encouraging evidence reinforces the importance of diversifying portfolios across factors and staying the course.

A Historical Look at Factor Returns and Recessions

Over the very long run, stocks and the economy are related. A better economy means better earnings and valuations for stocks. But the stock market is forward-looking. Investors don’t just wait for official confirmation of economic or company news, but rather act on what they expect to happen. How does this gap between economic performance and investor expectations play out in historic stock returns?

Chart 1 shows the average monthly returns for the Fama-French factors and momentum in a variety of economic environments. The data goes back to July 1926 and includes 15 recessions. The current recession is excluded as it has yet to run its full course.

15 past recessions going back to 1926

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

	Market premium (Mkt-RF)	Small size (SMB)	Value (HML)	Momentum (MOM)	Profitability (RMW)	Conservative investments (CMA)
All Months	0.67	0.19	0.35	0.66	0.26	0.27
Expansions	1.02	0.29	0.39	0.67	0.24	0.19
Recessions	-1.00	-0.23	0.18	0.57	0.40	0.86
12M Pre Recession	0.34	-0.22	0.62	0.98	0.71	0.53
12M After Recession	1.95	0.98	0.65	0.54	0.59	0.39

*Average returns through January 2020. Mkt-RF, SMB, and HML data starts in July 1926. Momentum data starts in January 1927, and profitability and investment factors data start in July 1963 Source: Ken French Data Library http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

As we see in the chart’s top row, all factors have positive returns when invested over the long term. Performance differences first appear when we look at the next two rows, which assign these months into two categories: expansions and recessions¹. During expansions, all factors are again nicely positive, and are statistically and economically significant. The story is somewhat different when we look at recessions: Both the market’s excess return and small size returns are now negative, and value returns are notably reduced.

These results are not surprising, given that the original Fama-French three factors, which built on the work of others, are often called “risk premiums.” While some have argued that these excess returns are due to behavioral considerations, there is ample evidence for both sides². During the tough times of a recession are exactly when risk shows up. Investors flee from risky stocks—especially the riskiest beaten down names. Conversely, investors seek out quality companies with good financial health. This helps explain the better returns of the profitability and conservative investment factors, which are stronger than typical during recessions.

Given that we have entered a recession, should investors cut their equity allocation? Or should they move exclusively to larger stocks with good company financial health? The answer is no, not necessarily, because those moves present their own risks.

First, the results above are true on average, but do not happen every single time. Second, factor results depend not just on whether there is a recession, but also on the specific economic and market environment of each instance. What occurs before and after a recession matters, and timing can be crucial.

Timing Matters

Factor behavior can change dramatically during the run up to a recession and in the subsequent recovery. Unfortunately, we can’t know exactly when recessions will begin or end. Those dates are determined by NBER, often well after the fact and subject to subsequent revision.

We see evidence of these shifts in market behavior in the two rows of Chart 1 that give factor returns before and after recessions. There is no standard way to define these periods, so for consistency and convenience we have arbitrarily chosen 12 months³. Periods before a recession are often marked by euphoria: The Roaring 20’s, the tech bubble of the 1990’s, and the period before the recent Great Financial Crisis are well-known examples. Such an environment is particularly reflected in the strong returns for momentum, as stocks that have done well continue their positive run.

Periods following recessions are often filled with cautious optimism about an improving future and increased risk appetite. This is when the stock market—particularly small and value segments—typically put in their strongest performance, reversing their recession blues. Trying to time the market and factor performance runs the risk of missing out on these very substantial gains. It’s not just when you get out, but also when you get back in that matters.

One recent example is that when the impact of COVID-19 became clear, the market sold off rapidly. It then rebounded in anticipation that the unprecedented monetary and fiscal stimulus will moderate the economic damage. Investors who abandoned stocks in anticipation of a recession may well have captured the downside but missed the subsequent rally we have experienced.

Case Study: Recession of 2001

Diving deeper into our data, the recession of 2001 is an interesting example of the risks of attempting to time recessions and adjust factor exposure. We chose to highlight this period because the strong returns for small and value stocks in the 2001 recession is a cautionary tale for those tempted to take refuge in large growth stocks now. The chart below shows the same factors as before, but isolates the months before, during and after this event only.

Recession of 2001 (March – October, 8 months)

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

	Market premium (Mkt-RF)	Small size (SMB)	Value (HML)	Momentum (MOM)	Profitability (RMW)	Conservative investments (CMA)
During Recession	-1.99	1.15	0.68	2.12	2.04	1.06
12M Pre Recession	-1.76	-1.74	4.54	-1.05	4.37	2.82
12M After Recession	1.95	0.98	0.65	0.54	0.59	0.39

Source: Ken French Data Library http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

While small size (SMB) and value (HML) have typically been negative or weak during a recession, both factors had strong returns in the recession of 2001. Large cap and growth stocks had dominated in the tech bubble that grew during the last two years of the 1990s and the first quarter of 2000. Their collapse not only helped usher in the subsequent recession, but also set the stage for historically cheap and beaten down small and value stocks to recover strongly. This outperformance continued after the recession ended. It’s also interesting to note that in the case of value, this reversal actually began before the official start of the recession, which would have provided an important cushion for portfolios that had maintained exposure to value during the tech bubble. That certainly did not happen for value investors before the current recession, but we still believe there is strong evidence that value’s performance will turn around in the future.

Key Takeaways

If timing recessions is hard and picking which factors would do well even harder still, what can investors do? We at Bridgeway go back to the importance of diversification. It is a crucial concept for all investors, and for Bridgeway it includes not just the way we invest but also how we run our firm and the people we hire. Bridgeway focuses on the three broad investment themes of value, company financial health, and momentum. Those stocks with the strongest factor exposures are often smaller, typically giving our portfolios a tilt to smaller size as well. As seen in the top row of Chart 1, all of these factors have worked over time. They usually don’t all work at the same time, and when one is lagging, others often do well.

Bridgeway therefore does not make dramatic changes to our portfolios because we are in a recession, and we think all investors should avoid the temptation. These moves are potentially costly in terms of trading needed to implement those changes and the substantial risks of not getting that timing call exactly right. Instead, we stick with our process and monitor our portfolios to ensure they maintain their targeted allocations to diversifying exposures. The run up to the current recession saw smaller and deeper value stocks lag by historic amounts. If history is a guide, we expect the fortunes of these factors to reverse as the current market cycle runs its course. We don’t know when that turning point will come, but when it does, we believe that investors who’ve maintained a diversified portfolio with broad factor exposure will be rewarded for their discipline.