It’s time to take stock ahead of the inevitable market downturn

The stock market has been going gangbusters for a number of years, so it is easy to forget that bear markets are still possible. These don’t come around on a set schedule, but over the past 70 years or so they’ve occurred every four to five years, on average. Although investors can’t predict when the next bear will strike, they should work through potential scenarios to be prepared when the inevitable downturn begins. Here are six questions to think about before the next bear market. How bad will things get? We’ve witnessed two of the largest market crashes in history in this century alone, so you should forgive investors for assuming stocks will get cut in half every time they go into bear market territory. History tells us enormous market crashes are rare. Since World War 2, there have been 15 bear markets. Only three produced losses exceeding 40% and there were three separate downturns in the 30% to 40% range. That means stocks fell no more than 30% two-thirds of the time. In fact, the median drop was 26%. A crash is always possible, but your baseline for a bear market shouldn’t be a huge meltdown.

Will emerging markets outperform the US? Emerging markets have badly lagged behind US stocks for the past decade. And although developing countries are typically more volatile than developed ones, the fact that emerging markets have performed so poorly could cause them to outperform the US during the next sell-off. GMO’s Jeremy

Grantham recently laid out the case for this. His view is that the relatively undervalued emerging markets should hold up better in a downturn than the relatively overvalued US shares.

Will actively managed funds outperform index funds? The huge flows into index funds and exchange traded funds has been in large part because of the futility of active fund managers’ efforts to outperform their benchmarks. One of the arguments from active money managers is that while they are falling behind in a raging bull market, they are sure to provide cover and outperform when it reverses course. According to data from S&P Global Ratings, that wasn’t the case during the past two bear markets.

Will managed futures provide positive performance in a down market again? Managed futures were one of the few strategies that held up well in 2008 when everything else got hammered, by providing positive returns during a market crisis. According to the BarclayHedge CTA Index, these funds were up more than 14% even as stocks around the globe fell 40% or worse for the year. This outperformance led many investors to add an allocation to this strategy, which seeks to follow trends in stocks, bonds, commodities and currencies, but it hasn’t worked out so well since then. From 2009 to 2017, this same index is up less than 6% and has had negative returns in six of nine years.

Will commodities provide diversification benefits? Like most risk assets, commodities fell off a cliff during the financial crisis. But unlike these other assets, commodities are still languishing far below their highs from the previous peak. The Bloomberg Commodities Index is still down almost 50% from October 2007. It will be interesting to see if commodities provide diversification benefits during the next stock bear market as they haven’t taken part in the huge gains since 2009.

How will cryptocurrencies react? The rise in cryptocurrencies has corresponded with a bull market in stocks. And while cryptocurrencies have experienced a number of bear markets and crashes over the past few years, we have yet to see how they will handle a bear market in stocks. — Bloomberg

Baseline for a bear market shouldn’t be a huge meltdown