Bear Markets: Always Different, Always the Same (EP.90b)

Episode Summary

Executive Summary: In this special episode of Rational Reminder, hosts Benjamin Felix and Cameron Passmore analyze the extreme market volatility during the COVID-19 pandemic, providing historical context on bear markets, discussing the behavior of bond ETFs versus NAV, and offering practical advice on tax-loss selling and financial planning. They emphasize the importance of staying invested, debunk myths about market recoveries, and highlight the potential for positive societal outcomes from the crisis.

Main Topics: Historical Bear Market Analysis (Priority: 5/5): Ben presents a detailed analysis of 27 US bear markets since 1900, including average drawdowns, recovery times, and the unique speed of the current downturn. He debunks the myth that the Great Depression took 25 years to recover from, showing it was 7 years in real terms. Bond ETF Pricing and NAV Discrepancies (Priority: 4/5): Discussion of the significant discounts to net asset value (NAV) seen in bond ETFs during the crisis, explaining the mechanics of NAV calculation, the role of authorized participants, and why ETF prices may reflect true market value better than NAV in stressed conditions. Market Timing and Behavioral Finance (Priority: 4/5): Analysis of the costs of market timing, including missing the best month in a recovery, and the psychological challenges investors face during downturns. Ben presents a model showing a 46 basis point annual return penalty for a naive market timing strategy. Tax-Loss Selling Considerations (Priority: 3/5): Updated guidance on tax-loss selling, highlighting the audit risk from CRA legislation beyond the identical property rule, and emphasizing the need for a high current tax bracket and expected lower future bracket to make it worthwhile. Factor Performance in Bear Markets (Priority: 3/5): Review of academic papers showing that value, profitability, and investment factors have historically provided downside protection during bear markets, with value premiums averaging +8-10% during the worst drawdowns. Government and Central Bank Responses (Priority: 2/5): Overview of Canadian fiscal and monetary policy responses, including reduced RRIF minimum payments, extended tax deadlines, and mortgage deferral programs.

Key Arguments: History never repeats itself, but human behavior does; the best comparison for COVID-19 may be World War II in terms of global cooperation and solidarity. The speed of the current bear market is unique due to rapid information travel, but the 1987 crash had a similar 30% drawdown within three months. Missing the best month in a recovery extends the time to reach the previous peak by 21 months on average (pre-1945) or 6 months (post-1945). Bond ETF discounts to NAV do not necessarily indicate a problem with the ETF structure; they may reflect accurate pricing of illiquid underlying bonds. Tax-loss selling carries audit risk because it goes against the intent of the legislation, even if CRA guidelines on identical properties are followed. Value, profitability, and investment factors have historically provided positive returns during the worst market drawdowns, acting as a buffer.

Data Points: Average bear market drawdown (1900-2019): 29% - Average peak-to-trough decline for 27 bear markets with at least 15% drop. Average recovery time (peak to peak): 40 months - From market peak to return to previous peak, including the decline. Post-WWII average recovery time: 26 months - Shorter recoveries after 1945 due to improved monetary/fiscal policy. AGG ETF discount to NAV (March 16): 4.43% - iShares Core US Aggregate Bond ETF traded at a 440 basis point discount. VSC ETF discount to NAV (March 20 close): 8% - Vanguard Short-Term Corporate Bond ETF closed at 8% below NAV. Great Depression real recovery time: 7 years - In purchasing power terms (including deflation), recovery from September 1929 peak took 7 years, not 25. Value factor premium during worst drawdowns (since 1927): +8.2% - Average annual value premium during the 10 worst US drawdowns. Market timing model annual return penalty: 46 basis points - Reduction in annualized return from 8.39% to 7.93% for a naive market timing strategy (1900-2019).

Pivotal Quotes: "History never repeats itself, but man always does." — Benjamin Felix (quoting Voltaire via Morgan Housel): Used to argue that while specific events differ, human behavioral responses to crises are predictable. "The decision to not sell was based on our inability to predict market changes. So, while the outcome sucks, this decision was correct." — Benjamin Felix (quoting a client email): Illustrates the importance of process over outcome in investment decision-making. "Disasters do not make societies panic; they bring them together in calm solidarity." — Benjamin Felix (quoting sociologist Charles Fritz via Morgan Housel): Suggests potential positive societal outcomes from the pandemic, similar to WWII.

Implications: Investors should stay disciplined, avoid market timing, and recognize that bond ETF discounts may reflect true market value. Tax-loss selling requires careful consideration of audit risk. Historical data supports factor-based diversification as a buffer during downturns. The crisis may foster increased cooperation and empathy, potentially leading to positive long-term societal changes.