Episode #76: History of Market Cycles in Nominal and Real Returns

• INTRODUCTION

François Doyon La Rochelle:

You’re listening to Capital Topics, episode #76!

This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss the history of market cycles with Raymond Kerzerho, Senior Researcher at PWL Capital.

Enjoy!

• HISTORY OF MARKET CYCLES IN NOMINAL AND REAL RETURNS:

François Doyon La Rochelle:

Good morning, James. How are you today?

James Parkyn:

I’m good. Francois, how are you?

François Doyon La Rochelle:

I’m very good. Thank you. So hello to you, Raymond, welcome back to the podcast. It’s a real pleasure to have you back.

Raymond Kerzérho:

Good morning, everyone.

François Doyon La Rochelle:

So we’ve invited Raymond to join our podcast today because he has recently published 2 blog posts covering the historical performance of stocks and bonds over the last 55 years.One of these blogs covers market cycles in nominal returns, and the other in real returns. These blogs are very interesting to us, so we felt that they would be of interest to you, our listeners.We thought once again that it would be fun to have Raymond, the author join us on the podcast to have him explain his findings.

If our listeners are interested in reading these blog posts, they are available on the Pwl Capital website in the ”Learn” section, we’ll also make sure to provide links to the blogs with this podcast for easy access. So Ray, as I said earlier, welcome back! I will go ahead with the 1st question. As I mentioned in my intro. Your blog post described the historical performance of stocks and bonds over the last 55 years. But what prompted you to write these blogs now, and why 2 separate blog posts on the same topic?

Raymond Kerzérho:

Yes. Well, let’s start with the purpose. The idea is that with all the noise, with the trade barriers, and all that is being raised with the United States, there is a lot of attention given to short-term phenomena in the stock market. My goal, really with this article was to say, well, let’s take a seat back for a bit and take a longer-term perspective on things. And actually, the 55-year period that I covered is pretty much the life of an investor.

For the second part of your question, why 2 blog posts, well in one of the blog posts I covered the cycles of nominal returns. Nominal returns reflect the psychological experience that we have in investing in the market, whereas in the second blog post, that is equally important, if not more, I touch on the real returns, so on all returns that are calculated, and that I documented in the blog post really, are adjusted for inflation to reflect the real value creation that’s going on there.

James Parkyn:

So, Ray, in preparing these blogs, as we mentioned, you looked at 55 years of capital markets history. So, starting in 1970. Can you please explain to our listeners why you decided on 55 years and can you also explain your methodology?

Raymond Kerzérho:

Of course. So the data starts in January or early 1970, and it ends at the end of 2024. Which gives us 55 years. It’s not something that I got up in the morning and said to myself, “Oh, let’s take 55 years”. It’s really because we started having international data every month only since 1970. We of course have international data dating back earlier than that. But it’s only annual or limited to the US. Stock market. I wanted to mimic the experience of a Canadian investor who invests on a global basis.

So I constructed 5 portfolios and focused on the the return data:

1. A portfolio that is fully invested in stocks. And it’s 30% Canadian stocks and 70% foreign stocks. So it’s a portfolio that’s very similar to the Etf of Vanguard for the global equity portfolio.
2. A fixed-income portfolio that is 100% Canadian bonds.
3. A portfolio that is 40% stocks and 60% bonds.
4. A portfolio that is 60% stocks and 40% bonds.
5. And the last one was 80% stocks and 20% bonds.

François Doyon La Rochelle:

So, Ray, your blog posts discuss stock market cycles as a process that repeats over time. And you make the case that there are 3 phases to these cycles. Can you explain these cycles to our listeners?

Raymond Kerzérho:

Yeah. When looking at the stock market cycle, I used an algorithm. So what the algorithm says is that the 1st phase of the cycle is the beginning of a bear market. A bear market starts when the market has reached its most recent all-time high, and ends after a cumulative decline of 20% or more and finds a bottom.

The second phase is the recovery portion. For the recovery, the phase begins at the bottom of the bear market and concludes when the market returns to its previous all-time high. In this recovery period, you have a positive return but are just a result of recovering from your losses in the bear market.

François Doyon La Rochelle:

Or in other words, getting back to where you were.

Raymond Kerzérho:

Yeah, exactly. Finally, the 3rd phase is the expansion phase, which begins when a recovery is complete and ends at the next Peak, marking the start of a new Bear Market.

James Parkyn:

So, Ray. One insight from your papers that I like is that there are many ways to define market cycles. For our listeners, can you elaborate a bit on this?

Raymond Kerzérho:

Well, if you’re trying to define what’s a bear market or market cycle, you need to decide what type of data you’re using. My choice was to use total returns. So my data includes dividends and interest payments. I look at the returns of stocks and bonds, which have an effect as dividends, are added to the return. On the other hand, I use monthly returns.

So if we take the polar opposite of what I have done and use daily data and daily price data excluding dividends, you would probably find higher highs and lower lows, because you have a much higher frequency in the data. As I wanted to document value creation, it was very important to include the interest and dividends in the payment.

So basically, I got to admit that in my study by using monthly data and total return data, I tended to lowball a little bit the frequency of bear markets, and how extreme they are.

James Parkyn:

Just an example is this past April when we had extreme volatility. But if you sort of looked at your portfolio at the end of March, and then the end of April, without any access to any financial media noise, you would have thought, “Hey, this wasn’t a very volatile month!” when in reality it was a very, very volatile month.

Raymond Kerzérho:

There you go!

François Doyon La Rochelle:

Yeah, there’s been quite a few market corrections over the year, and like James just mentioned, we just lived one in the US in April.

Raymond, Can you clarify for our listeners the difference between a market correction and a bear market?

Raymond Kerzérho:

Well, a market correction. I think most people in the industry would agree that it’s a downward movement in stocks by at least 10% And up to 20%. Past 20%, we’re talking about a bear market. But bear markets are not all equal. Some bear markets, Just stop shortly after reaching – 20%. But then you’ve got severe bear markets. So in my study, the most severe bear markets result in losses of more than 40%.

James Parkyn:

For most investors, their experience dates from 1990 or since then. Your study covers the period since 1970, and in that period, we witnessed a -40% bear market. I think we’ve only had a couple on our last podcast where we looked at the UBS Yearbook with the collaboration of Professor Dimson, Marsh & Staunton data, that they identified 4 big bear markets in the last 125 years, 2 of which have been since the 2000s. So think of the tech bubble bursting and the global financial crisis. But so really, that’s what most investors are really afraid of. Those big deep – 40% or worse bear markets that last a long time.

So Ray, based on your 55 years of data, do you agree with the UBS yearbook that there have been 2 severe bear markets?

Raymond Kerzérho:

I would say that based on my data, there are light bear markets and severe bear markets. I look at the past 55 years, there was the oil shock in 1973-74, where we noticed a large downward movement in stocks, and the other part was really the tech Krash in 2000. So it depends. If you look on a nominal basis, the tech Krash and the financial crisis were 2 severe bear markets. With the tech Krash, the market crashed. It recovered, just barely recovered, and then it crashed again in 2008.

So if you consider it on a nominal basis, there were 3 big bear markets, major bear markets in the last 55 years. I would like to add in terms of what investors should expect. In my review I found an average of 1.3 bear market per decade, so investors should expect at least one bear market in every 10 years.

James Parkyn:

Yeah, with most of them being in the – 20, – 25 range.

François Doyon La Rochelle:

Ray how long do these bear markets last?

Raymond Kerzérho:

It’s very, very volatile. There was one bear market that lasted only 3 months, like after the crash of 1987, and the recovery started shortly after. On the other hand, the tech Krash of 2000 lasted 2.5 years.So bear markets can be quite long, and they can be very short. We really cannot forecast how long a bear market is going to be.

François Doyon La Rochelle:

Ray, how much can investors expect to lose in a bear market? Or historically, how much have they lost?

Raymond Kerzérho:

So, I’ll give you the nominal and the real numbers, the nominal numbers are, of course, a little bit less extreme. So for the oil shock of 73-74, it was – 42%. And for the financial crisis, it was like – 43%. So the difference between those 2 was quite thin. And it’s the same thing for the real returns. If you look at the real return. The oil shock was like – 48%. Almost half of the portfolio value was deleted there and then. And that’s in real terms. That’s because there was a lot of inflation back then. A similar story in the same period, from the tech Krash to the end of the financial crisis, the total return net of inflation was like – 47%.

François Doyon La Rochelle:

Yeah, just to reassure our listeners here a bit. These losses are for a 100% equity portfolio, right.

Raymond Kerzérho:

Yeah, yeah.

James Parkyn:

So, Ray, in your research, what can you say about how long it takes, on average, to recover from a bear market

Raymond Kerzérho:

Once again. It’s very variable, but for sure it depends on the severity of the bear market that has preceded deep losses, and of course, it takes longer to recover from on a nominal basis. The longest recovery was 4 years following the financial crisis of 2008-09, and you would have not made any money during the recovery. You’ve just recovered your losses.

James Parkyn:

In fact, it’s often referred to as a lost decade, because when you look at the end of the tech bubble and then the global financial crisis, you know, at the Peak, I believe the S&P 500 was at 1,522 in March of 2000, and it bottomed in March of 2009 at like in the 600s. So if you look at your start and end data points, are, you can say, “Wow! There’s a lost decade there!”

François Doyon La Rochelle:

Yeah. Well, it was a lost decade for the US. But it wasn’t a lost decade for Canadians.

James Parkyn:

Very good point you make, Francois. I agree, and that’s where we’re globally diversified for that very reason.

Ray, we often tell our listeners that Downside arithmetic is not the same as upside arithmetic. To be clearer, if the market drops by 20% near 100% equity, then get back to where you were, your portfolio has to gain 25%. Obviously, if you have a deeper, 40% large loss, it’s an even bigger gain required because you only have 60 cents left to get back to a dollar.

Raymond Kerzérho:

James, I agree with you 100%. And if you take more extreme examples, let’s say you lost nearly 50% in the severe bear markets, you need a 100% return to recover from that. However, there’s a silver lining to having a very bad period in the stock market. It tends to recover very, very strongly afterward. So you can have a lost decade, but you’re going to have a very strong recovery eventually.

James Parkyn:

As we mentioned in our previous podcasts, you can’t guess when that turnaround is going to happen. And it’s that early turnaround phase that gives you that great long-term performance. So that’s where time spent in the market is so much more important than trying to time the market.

François Doyon La Rochelle:

Yeah, just remembering the 2000, March 2009, when the market started recovering. Boom! A couple of days, and it was off. And you missed those 1st couple of days when the markets were positive. It would surely have an impact on someone’s portfolio if they weren’t invested.

Next question for you Ray, how long do expansion phases last, and what were the returns?

Raymond Kerzérho:

Yes, as I was mentioning before, there’s a lot of positive in all that, even though a bear market can be extremely difficult for investors when you get into recovery, and then the expansion, it can be very lucrative. Expansions can be 0 like after the crash of 87 there was really no expansion. We had just a recovery. Then we fell back into another bear market.

So that’s one side of the story. The other side of the story is that you can have a recovery lasting 10 years or more with an inflation-adjusted compound return range between 0 and 154% that you can get in the recovery and not in the expansion phase. So sometimes stock returns are depressing, but sometimes they are so high they appear to be too good to be true.

James Parkyn:

So, Ray, in your blog. You’re often referring to the stock market as a money-multiplying machine. This is what all investors hope for that’s why they’re prepared to accept negative volatility or the deep bear markets, or the less deep bear markets in the short term. And we spend a lot of time on our podcast you know, discussing investor psychology and good behavior and bad behavior. So in your blogs, you elaborate on both real returns, as opposed to nominal returns. Can you clarify your findings for our listeners between real and nominal returns?

Raymond Kerzérho:

Yeah, well, I think the real important part is here about value creation. And I’ve put a table in my second blog post on real returns, looking at the net wealth, creation of a dollar invested at the beginning of 1970, and then by decade. And what I found is that in some decades you don’t make money at all like in the seventies. You were pretty much at the same place at the end of the decade there than where you were at the beginning of the decade. But after that, when the market turns around, there’s a lot of value creation. So basically, what I found is that over 55 years, when you average all these bad periods and extremely good periods for the stock market, the all equity portfolio dollar invested at the beginning of the period, multiplied by 16 times.

François Doyon La Rochelle:

Well, okay, and that’s the real return. Right?

Raymond Kerzérho:

That’s the real return. I’ll give you a few other numbers. Even a 60/40 portfolio multiplied by 12 times. The other one I’d like to mention is the all-fixed income portfolio that multiplied by 6 times. But it’s really important to note that the returns on Canadian bonds in that period were extremely positive. I wouldn’t expect that type of number looking forward to the future, but the numbers on equity are quite realistic.

François Doyon La Rochelle:

Out of the 5 portfolios you’ve mentioned, Ray in your study, which one of them appears to be the most stable throughout the period?

Raymond Kerzérho:

So when you look at this table that I mentioned earlier by decade, what you’ll find is that the stock portfolio has lost money in at least one in one decade, and I was in a standstill over another decade, and made quite a lot of money in the other decades and also the 5 years since 2020. If you look at the bond market, you also had a negative decade in the seventies.

François Doyon La Rochelle:

A negative decade in bonds?

Raymond Kerzérho:

Oh, yeah, you can lose money over 10 years in bonds. Bonds are not as safe as people think, because they’re very exposed to the risk of inflation. In the 1970s we had a problem with inflation.

But just to come to my main point, it’s the 2 balanced portfolios: the 40% equity, 60% fixed income, and the 60% equity, 40% fixed income, that never lost money in a decade. And I’m talking about actual decades, the 1970s, the 80s, and so on. I don’t see a decade where they lost money. Sometimes they did not make huge returns, but they made money in every decade.

James Parkyn:

I would add an interesting anecdote to your finding Ray. What clients have said to us: “Boy, I get it. The benefit of a balanced portfolio this year. That’s globally diversified”, because, you see, for so long, for almost 15 years, the US. Equity outperforms. And then this year they had the stability of their bond, acting as it should as a shock absorber. And they had, you know, Canadian equity, which is close to breaking even a little bit of return. And then they’ve had, you know, international equity, which has done quite well in comparison, obviously to the US. Equity was down.

So clients are seeing that. And in fact, I’ve seen data where you know up until somewhere, like in 2020, with a 60% equity, 40% bond portfolio, you’d get 85% of the all-equity return with a fraction of the volatility. So that’s not a free lunch. But it certainly is perhaps the portfolio that people can stick with. And We did the podcast last year with Professor Cederberg’s research where he said, you have to look at the long-term real returns. And that supports the research you’re sharing with us today that you can get periods where bonds and on a real return basis are going backward.

So you can’t assume that it’s a safe bucket in real terms. So again, these are very important findings that are consistent with what other academic researchers are producing. So we, as portfolio managers, find that very helpful. So, Ray, to conclude, can you highlight what are the most important lessons you draw from these 55 years of market data?

Raymond Kerzérho:

Of course. So really, the 1st thing that I see in this data is, do not interrupt the compounding by actively trading in your portfolio. If you’re making active decisions, it just disrupts the process of compounding the returns on the portfolio. And this process is a little bit complex because it’s not like compounding. You buy a bond, and it compounds over 55, or several years. It’s you have to deal with the ups and downs of the stock market. Trading in a portfolio interrupts the compounding of returns.

The other thing is to think long-term. Some people will maybe mock the idea of taking a multi-decade investment horizon. But it’s really the way to achieve exceptional returns in my view and create a lot of of wealth.

Number 3 is really the early dollars that are the most productive. Young people have a lot more power than they think. Starting to invest when you’re young is making a decision to be rich later in your life.

Another one really is that growing wealth requires a substantial allocation to equity. I’ve been reading recently the book by David Swenson, former manager of the Yale Endowment, and he says exactly that. He says it’s really the equity portion of the portfolio that generates a lot of wealth.

The bonds are still important to provide some stability, but it’s really the equity that is creating value.

I’ve got a couple more. Some periods are tougher in the market and periods are much more prosperous. Investors should consider adjusting their savings and spending patterns to portfolio performance.

So the most important case is for retirees. You set yourself a budget of how much you can spend. Well, if you want to make sure not to outlive your money, the best thing to do is to adjust to the market a little bit. So, if the market has a bad year, maybe try to spend a little less, and if the market delivers very high returns, you can then afford to spend a little more as well. I don’t want to give morals to people, or something like that. The idea is, that it’s mathematic. If you adapt toward the market performance, you have better odds of not outliving your portfolio and the same thing for people who are saving. If you have very high returns for a period, and you have at one point more savings than what you need then that’s more towards achieving your goals and you can save less. On the other hand, if market returns are terrible, you need to put a little more money aside for the future If you want to achieve your long-term goals.

Last thing investors should hold on to their portfolio and expect bear markets as a normal part of investing. So it’s really hold your portfolio. Stick to your asset allocation, rebalance, and never bail out during crashes. Never, never do that. Your portfolio is there. You should think about your portfolio as a thing that is there for life. It’s not a temporary thing. It’s there for life.

François Doyon La Rochelle:

Well, thank you, Ray, this was insightful. I think we’ll conclude our podcast here. I think our regular listeners will agree that these lessons are exactly at the core of our investment philosophy and that they will help them continue to focus on the long term and have an appreciation of the loss of risks and return. As I said, at the outset of this podcast we’ll make sure to put the links to Ray’s blog posts on the podcast page on this.

CONCLUSION

François Doyon La Rochelle:

Thank you, Ray for our participation today, as usual this was very interesting, and I hope our listeners have found it interesting as well.

Raymond Kerzérho:

You are welcome, Francois.

François Doyon La Rochelle:

I remind our listeners that Raymond’s blog posts can be found on PWL Capital’s website in the learn section. Also, thank you James for your contribution again today.

James Parkyn:

My pleasure, François.

François Doyon La Rochelle:

That’s it for episode #76 of Capital Topics!

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