Bearer of Bad News for Broad Market Indexes

by Justin Lowry, CIO, Global Beta Advisors

Prior to the global health pandemic that has taken financial markets by storm, investing over the past decade had effectively been on autopilot with broad market indexes setting new highs constantly over that time. Since the market bottomed from the Financial Crisis of 2008/2009 on 03/09/09, the S&P 500 Index has yielded an average annualized return of 13.09% through 12/31/19 (Source: Factset Research Systems). This led many investors to question, “Why would I pay a hedge fund manager or a financial advisor when I can simply buy the S&P 500 Index myself?” If you had that mindset for the previous 10+ years, you were rewarded time and time again. However, as the Financial Crisis of 2008/2009 became a distant memory, it has been forgotten by some that there are names in the S&P 500 Index that may not be investment worthy, especially in tough times. While the elite members of the S&P 500 Index (i.e.: the companies with the largest market capitalization) may indeed carry the index back from the brink of the bear market that has resulted from the COVID Crisis, we believe there will be a chunk of the index that is left behind, and thus, curbs the potential of the broad market index. It begs the question: is active management back? For context, we look back at the past two bear markets: the “tech wreck” of the early 2000s and the financial crisis of 2008/2009.

Factor Investing

Tech Wreck
The “Tech Wreck” came in the wake of a major surge of investment in the information technology sector.  This ultimately drove up the performance of the broad market, and subsequently, the valuations of the broad market.  There was a pent-up demand for a strong technological infrastructure in the face of Y2K (the acronym for “The Year 2000”), whereby, the prevailing thought was that the transition into the new century would disrupt computer systems around the world.  As the demand waned subsequent to the turn of the new century, the rich valuations were exploited and resulted in a bear market sell off as several companies, particularly in the information technology sector, fell victim to bankruptcy.  To compound that backdrop was the terror attacks on 9/11/01, which further strained the national economy.  The recovery rate that ensued, as illustrated below, was of a long, slow variety:

“Tech Wreck” Bear Market RecoveryTech Wreck ChartSource: Data from Factset Research Systems

The above chart is an illustration of the S&P 500 Index when it reached “bear market territory”, which is defined as a 20% decline from a recent high, and the recovery horizon both as an index as a whole as well as the components within the index.  The latest high in that period occurred on 3/24/00.  On 03/12/01, the S&P 500 Index crossed into bear market territory from that high.  The blue line in the graph is the percentage of the losses that were recovered in the subsequent one, three, and five years from the beginning of the bear market.  A couple of observations can be made here.  The broad market index never fully recovered its losses even after five years, however, 60% of the names that were in the index at the time of the bear market did recover their all-time highs from 03/24/00.  In fact, the broad market as a whole only recovered just under 30% of its losses with nearly 40% of its components never recovering from its all-time highs, thus inhibiting the index from fully recovering its losses.

The Financial Crisis of 2008/2009
The Financial Crisis of 2008/2009 resulted in a recession that rivaled the Great Depression in terms of both economic contraction by GDP as well as unemployment (Source of data:  Factset Research Systems).  The catalyst was a ballooning debt bubble primarily in residential mortgages.  The standard for banks to approve new applications was quite low, which resulted in many “subprime mortgages”, which are mortgages issued to borrowers with low credit scores and a higher debt-to-income ratio, throughout the nation.  To compound the issue, these subprime mortgages, unbeknownst to the underlying investors, were securitized along with “good” mortgages and sold in the market.  The last leg in the stool was the fact that the capital requirements for banks at the time were quite low, which proved to be fatal when their subpar balance sheets began to face a slew of defaults and a resulting recession.  As the defaults on the subprime mortgages began to take hold of the market, it put unprecedented strain on capital markets.  The unraveling of the market resulted in the federal government issuing large bail out packages to financial institutions that were deemed “too big to fail”, which was to describe institutions so large that if they fell insolvent, the entire U.S. economy would collapse under its own weight.  Additionally, the Federal Reserve immediately reduced the federal funds rate, which is the overnight lending rate to commercial banks, to 0%(Source of data:  Factset Research Systems).  The Federal Reserve also began a bond purchasing program named “Quantitative Easing” (QE), which was intended to purchase high risk or bad debt from the credit markets to increase liquidity and alleviate the default risk that was born upon investors.  While imperfect, the actions by the federal government and the Federal Reserve did put a backstop to an imploding U.S. economy.  Again, the recovery rate was long because of the magnitude of the recession, but the actions from the Federal Reserve proved to be imperative to the ultimate recovery as shown in the graph below:

“Financial Crisis” Bear Market RecoveryFinancial Crisis Bear Market RecoverySource: Data from Factset Research Systems

In contrast to the bear market from the “Tech Wreck”, the recovery from this bear market proved ultimately to be more robust, although the up-front pain was more paralyzing.  The all-time high prior to this bear market was recorded on 10/9/07.  The S&P 500 Index officially crossed into bear market territory from that all-time high on 7/9/08.  As illustrated on the graph above, the S&P 500 Index actually recovered all of its losses incurred from the Financial Crisis by year 5.  However, you’ll notice in the chart above that the damage to the individual components of the index was more acute than the Tech Wreck.  By year 3, only 46% of the components had recovered their all-time highs, despite the index having recovered over 30% of its losses from the bear market.  By comparison, five years from the Tech Wreck bear market, around 30% of its losses had been recovered as well, however, 61% of the index components had fully recovered.  That means that the recovery from the Tech Wreck was led more broadly by the index vs the Financial Crisis, which was led more narrowly.  However, after five years, 60% of the index components had recovered to their all-time highs vs 61% of index components during the Tech Wreck.  While that is still an impressive recovery rate when measuring its progression over time, we still saw in each bear market that 40% of the index components never recovered their all-time highs even after five years from their respective bear markets.


COVID Crisis
The COVID crisis is a global health pandemic that originated from a strain of Coronavirus, dubbed “COVID-19”, in Wuhan, China.  “COVID” is an acronym that standards for “COronaVIrus Disease” and “19” is the year that it originated (specifically, December of 2019).  COVID-19 is a highly contagious respiratory disease that carries a relatively high hospitalization and mortality rate relative to other infectious diseases.  Its relatively long incubation period, which is the time it takes for one to become symptomatic from when they contract a disease, as well as those who may never demonstrate symptoms, has largely contributed to the virus being highly contagious (Source: Centers for Disease Control).  That coupled with the inability to test for the disease makes it difficult to determine who and how many people have it, thus, leading to individuals inadvertently spreading the disease.  Given its high hospitalization rate, high mortality rate, and difficulty to trace; countries throughout the world issued “stay-at-home” orders to all residents to reduce the transmission of the disease, and thus, alleviate the hospitalizations and deaths that result from the virus.  While those measures were able to reduce the disease from exponentially infecting the world population, the economic consequences have been dire.  In about 1.5 months since the U.S. federal government first issued public health guidelines to mitigate the spread, the U.S. economy has seen all jobs that were gained since the end of the Financial Crisis eliminated (CNBC).  With individuals ordered to stay at home, industries such as retail, travel, and energy have been gravely impacted.  With consumers unable to leave their homes, many companies within those industries are beginning to face solvency issues in the face of their debt obligations vs non-existent revenue and limited capital resources.  Learning from actions taken during the Financial Crisis, the federal reserve and the U.S. treasury have taken unprecedented financial actions to support both small businesses throughout the country as well as stabilize credit markets.  The two government agencies have spent over $6 trillion collectively (Source:  The Federal Reserve).  The treasury department has issued stimulus checks to lower income individuals, expanded unemployment insurance, and provided loans (forgivable in some cases) to qualifying small businesses.  Global Beta believes that the velocity of the economic shock during the COVID Crisis is greater than that of the Financial Crisis, however, we also believe that the duration will be shorter and the timing and the magnitude of the actions by the federal reserve as well as the federal government will greatly impact the recovery rate of the economy.  However, we also believe that, similar to the two prior bear markets and resulting recessions, there will unfortunately be a great deal of losers.  Although the sample size is very limited right now, below is an indication of the recovery rate thus far from the bear market created during the COVID Crisis:

“COVID Crisis” Bear Market RecoveryCovid Crisis Bear MarketSource: Data from Factset Research Systems

The S&P 500 Index entered bear market territory on 3/12/20 from its all-time high created on 2/18/20.  Early indications show that the S&P 500 Index is recovering faster than its overall components.  Nearly half of the bear market losses have been recovered, however, only 7% of the names in the S&P 500 have recovered their all-time highs.  Although it’s early to make any real determinations, the trajectory currently is indicating that the S&P 500 Index may recover faster than prior bear markets, but that there may be many more laggards in the index this time.

What we do know from the prior two bear markets is that, even in the medium term, it is likely that at least 40% of the index will not recover its bear market losses.  The S&P 500 was never able to recover its bear market losses five years after the bear market during the Tech Wreck, but it was able to recover its bear market losses plus additional modest returns five years following the bear market during the Financial Crisis.   It’s very difficult for an index to make a full recovery when 40% of its components are unable to recover themselves.  For these reasons, Global Beta believes factor investing is more prevalent now than ever.  We believe making tactfully targeted approaches in the market lend to higher probabilities of medium and long term success by reducing exposure to potential losers in your portfolio.