The bear is back — Out of hibernation so soon?

by Global Asset Allocation Strategy Team

Key takeaways

• U.S. equity markets entered bear market territory on June 13 as concerns about elevated inflation, slowing economic growth, and aggressive Federal Reserve (Fed) policy rattled the markets.

What it may mean for investors

• Historically, diversified portfolios have helped investors weather equity volatility and often have recovered more quickly than individual asset classes.

Equity markets have been declining for most of the year after peaking on January 3, 2022, with the S&P 500 Index officially entering bear market territory on June 13. The decline started as investors fretted over the sustained high level of inflation and the Fed’s plans for aggressive monetary policy tightening. Since January, the war in Ukraine and its impact on markets exacerbated the inflation pressures triggered by supply chain disruptions and growing consumer demand as economies emerged from the pandemic. Moreover, in more recent meetings, the Fed announced its determination to fight inflation, indicating less likelihood of moving away from an aggressive stance.

Concerns about the impact of inflation on the consumer and whether the Fed will be able to navigate a soft landing for the economy have further rattled markets. Growing economic, geopolitical, and market uncertainties have all contributed to the current volatile market environment; we do not anticipate the choppiness will ease soon, unlike the previous bear market sparked by COVID-19. In 2020, a record short bear market commenced on February 19, hit the -20% threshold 16 trading days later on March 12, bottomed another seven trading days after that on March 23, and recovered within five months on August 18. It was the shortest bear market in history (Table 1), as global governments provided stimulus to consumers and central banks provided liquidity to the markets. In contrast, it took the current bear market 111 days to reach bear market territory, and we expect it will take time to repair as major central banks are prepared to tighten in order to contain inflation.

No one knows for certain how long and how deep this bear may be, but a look back at previous bear markets may give us some historical context. Historically, bear markets have occurred, on average, once every cycle and typically are much longer-lived than the 2020 bear market. Since 1929, bear markets have averaged slightly less than 11 months in duration and have experienced an average S&P 500 Index return of -35.5%.

Table 1. A history of bear markets

Sources: © 2022 – Morningstar Direct, All Rights Reserved1, and Wells Fargo Investment Institute, as of June 24, 2022. For illustrative purposes only. The S&P 500 Index is a market-capitalization-weighted index considered representative of the U.S. stock market. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

*Current bear market data is as of June 24, 2022, with the peak on January 3, 2022 and trough on June 16, 2022. Averages do not include the current bear market.

It is important to note that Wells Fargo Investment Institute‘s investment objective allocations carefully weigh market volatility risk against the potential for long-term growth in the value of the portfolio. The goal is to construct a mix of asset classes designed to provide a path of returns calibrated to the volatility risk an investor is willing to assume. In other words, allocations aim to match specified risk and return objectives.

Chart 1 shows our strategic allocations’ exposure to equities for potential long-term growth and their exposure to fixed income for potential stability and income generation. Some allocations also may include hedge funds for the diversification benefits that they may provide for qualified investors. In today’s volatile market environment, asset allocations that favor fixed income have been faring better than those that favor equities, despite fixed income asset classes this year experiencing the worst losses they’ve seen in several decades. This is in contrast to last year’s returns, when both equities and fixed income posted positive returns, and the returns we expect for both asset classes over the course of a full market cycle (a full bull market and a full bear market).

Chart 1. WFII’s asset allocations for a range of investment objectives

Source: Wells Fargo Investment Institute (WFII); as of July 19, 2021. Chart is conceptual and does not reflect any actual returns or represent any specific asset classifications.

As Chart 2 illustrates, financial markets can be extremely volatile on a short-term basis, and some investors may be unwilling to tolerate sizable drawdowns in their portfolios. One way to participate in the financial markets, while potentially minimizing wild swings in investment portfolios, is through asset allocation. Having exposure to a diversified mix of asset classes that do not always move in the same direction historically has provided some downside risk mitigation. The inclusion of real assets in a portfolio, such as commodities, and alternatives, such as hedge funds, has helped mitigate downside risk this year.

Chart 2. Year-to-date returns of hypothetical diversified portfolios and individual asset classes

Sources: © 2022 – Morningstar Direct, All Rights Reserved¹, Bloomberg, and Wells Fargo Investment Institute Total return from January 1, 2022 to June 24, 2022. Global Hedge Funds and Mod Growth & Income Illiquid (4AG) are as of May 31, 2022. Hypothetical portfolio returns are shown in the striped bars—individual asset classes (indexes) are in the blue bars. 3AG = three asset group. 4AG = four asset group. Performance results for the WFII Liquid (3AG) and Illiquid (4AG) portfolios are hypothetical and presented for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes.

Market downturns have historically taken time to recover, typically longer than the fast-paced recovery from the 2020 bear market. Portfolio diversification historically has been a tool to both help mitigate downside risk and aid in accelerating recovery time. In past cycles, our research suggests well diversified allocations did not take as long as the S&P 500 Index to return to the previous peak after markets fell (Table 2). Chart 3 highlights periods throughout the past 40 years in which the S&P 500 Index entered a correction or bear market territory. The chart also shows how a hypothetical diversified allocation generally has not experienced losses that were as sharp as those of an all-equity position (based on S&P 500 Index) during equity market drawdowns. Although fixed income has suffered losses during this downturn, we do not expect that fixed income and equities will remain highly correlated in the long term. We continue to believe bonds play an important role in risk mitigation.

Chart 3. Diversification may reduce downside risk during a correction or bear market

Sources: © 2022 – Morningstar Direct, All Rights Reserved1, and Wells Fargo Investment Institute, as of June 24, 2022. Current bear market is peak to trough drawdown as of June 21, 2022, with trough date of June 16, 2022. Performance results for the Moderate Growth and Income Liquid (3AG) Portfolio is hypothetical and is presented for illustrative purposes only and does not represent an actual investment. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes. Note: Corrections are declines of 10% or more. Bear markets are declines of 20% or more.

Using the same corrective periods from Chart 3 (with the exception of the current drawdown), we examined how long it took to recover to the prior peak. Table 2 shows that, on average, historically the MGI Liquid (3AG) diversified allocation recovered in less time (under a year, on average) after a bear market than the S&P 500 Index (just under two years).

Table 2. Diversification may help recovery times after a downturn

Sources: © 2022 – Morningstar Direct, All Rights Reserved1, and Wells Fargo Investment Institute, as of June 21, 2022. Same timeframes used as in Chart 3. Index return information is provided for illustrative purposes only. Performance results for the Moderate Growth & Income (MGI) Liquid (3AG) Portfolio are hypothetical. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance do not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes. Note: Corrections are declines of 10% or more. Bear markets are declines of 20% or more.

Although bear markets have typically been relatively short-lived, how investors react (or do not react) can be extremely important in meeting long-term financial goals. We have offered guidance for shorter-term tactical adjustments to our strategic allocations that we believe can help to reduce risk and improve overall return. For our tactical positioning, we stress quality as we transition to late cycle and a likely recession. In fixed-income portfolio positioning, we prefer short- and intermediate-term fixed income over long-term fixed income, which carries a higher duration (a measure of a bond’s interest rate sensitivity) risk as interest rates rise. We also favor Investment Grade Fixed Income over High Yield Fixed Income as we suggest moving up in credit quality. In equities, we also have continued to stress our preference for quality asset classes and sectors. We currently favor U.S. over international equity markets and large- and mid-cap equities over small caps. In addition to our unfavorable guidance on small caps, we are unfavorable on Emerging Market Equities and most unfavorable Developed Market (ex-U.S.) Equities. From an equity sector standpoint, we prefer Information Technology, Health Care, and Energy for their high quality and defensive characteristics.

We believe that the best investment approach is to set a strategic asset allocation that represents an investor’s goals, risk tolerance, and time horizon — and to rebalance back to those strategic targets on a regular basis. We caution investors not to be overly cautious or led by fear. Trying to time the market during periods of heightened volatility is extremely difficult. Yet, investors may want to consider employing tactical asset allocation to make modest adjustments to portfolio allocations based on a nearer-term (6- to 18-month) outlook. These actions, combined with maintaining a well-diversified asset allocation, may assist in reducing downside risk and could help a portfolio to recover more quickly after negative market-moving events.

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