Good morning friends!

With the markets down for the week, I thought I’d share some insight into how to think about bear markets.

What can we predict — and what can’t we? More importantly, how can we use today’s information to make better long-term decisions?

While I don’t foresee a bear market on the immediate horizon, the economic and political worlds are sending mixed signals. That uncertainty could tilt the risk/reward balance in the coming 12–18 months.

This doesn’t mean we react. But it does mean we should take a good look at how we’re strategically positioned — and remind ourselves what we’re willing to experience in pursuit of our goals.

📽️ I also just released a YouTube video breaking this down in plain English. If you’d rather watch than read, you can check it out here.

I hope the insights below serve you well as you navigate today’s markets.

Your co-pilot,

Daniel

FINANCIAL TOOL
What 15 Bear Markets Teach Us About Today’s Risks

We’ve been enjoying a bull market since October 2022 — placing us just over 33 months into this positive trend.

While the specific timing of bear markets has a way of sneaking up on most, there are certain qualities of bear markets that can help us manage our expectations, and risk, more strategically.

Looking at 15 bear markets since 1950, we can draw the following information.

The magnitude and length of bear markets that were accompanied by a recession were significantly greater than bear markets that did not parallel a recession.

• A non-recessionary bear market declined an average 22% and lasted an average 3 months.

• A recessionary bear market declined an average 35% and lasted an average 18 months.

What does that mean for today?

Firstly, the one we want to watch out for is the recessionary bear market!

The non-recessionary bear market, on average, is far shorter and shallower than its recessionary counterpart.

Short-term downturns are less damaging when recovery is swift — which is why long-term success hinges more on time in the market than timing the market.

Ever since February of this year, the uncertainty and unpredictability of tariffs has caused a sort of wait-and-see mentality among businesses. Economic data still shows modestly healthy levels on the whole, but the no-fire-no-hire attitude of many businesses reflects the broad sentiment that remains cautious of recession.

Remember that in 2022, the vast majority feared impending recession from nearly the start of the year through the end. And yet no recession actually materialized.

The longer a recession is anticipated, the less likely it generally is to actualize. Why? Because companies and individuals naturally adjust to conserve resources in this environment, and if those adjustments don’t send the economy into reverse, then the likelihood of recession becomes significantly lower.

We’re not out of the woods yet, though. Job growth has been notoriously slow these past few months, which could eventually lead to rising unemployment and recessionary numbers if it continues long enough.

The good news is that the Federal Reserve has plenty of room to lower rates, potentially keeping loan growth robust and possibly even accelerating it.

When long-term interest rates are lower than short-term interest rates, a recessionary bear market is more likely to result — unless the government spends more money to prop up the economy.

This phenomenon is known as an inverted yield curve.

It’s not a perfect predictor of recession these days. But recessions rarely happen without it. And yield curves rarely invert unless the Federal Reserve is raising rates.

Currently, they’re not raising rates, and not expected to.

So why do inverted yield curves often accompany recessions? A big reason is that banks are disincentivized to lend.

Banks make money by borrowing at short-term interest rates (think savings accounts, for example) and lending on long-term interest rates (think mortgages, auto loans, etc.). If banks make little to no profit doing this, why would they take the risk?

Fewer loans mean less money to go around. And less money for long enough generally leads to recession.

While the yield curve is basically flat in the US (looking at the 3-month vs 10-year Treasury yield), the yield curves across the rest of the developed world have been steepening recently — a positive sign!

Bear markets tend to run deeper when valuations are high.

The price-to-earnings (P/E) ratio gets a lot of attention when it comes to predicting markets. But in reality, markets can go a very long time at high valuations. The P/E ratio is rarely any good for trying to time a downturn.

But the Shiller P/E Ratio (which is a modified version of the basic P/E ratio) can help predict how bad the bear market will be when it eventually does come.

I like to compare the Shiller P/E ratio with its average past ten years. If it’s above its 10-year average, it’s high. If it’s 1.25x its 10-year average, it’s very high. Currently, it’s at about 1.23x its 10-year average.

So while we can’t use it to time a bear market, we can use it to predict that when a bear market occurs, it’s likely to be a deep one unless the market can slow down and allow earnings to catch up with its pricing.

What performs best (and worst) during a bear market?

Historically, the following types of stocks have tended to perform best during bear markets:

• Low volatility (measured by standard deviation)

• High dividend payers

• High quality

Historically, the following types of stocks have tended to perform worst during bear markets:

• High volatility (measured by standard deviation)

• Small / mid-cap

• Growth

These are not hard and fast rules, and they also depend on whether the bear market was accompanied by a recession or not.

But knowing what styles performed worst over a bear market drawdown period tends to give a strong indication of what is likely to outperform when the new bull market begins.

Conclusion

In the US, we’re experiencing a moment when:

• Recession fears are moderately high

• Long-term rates are relatively flat with short-term rates

• Stock market valuations are very high

Based on the historical data, this doesn’t tell us when the bull market is coming to an end.

But it does tell us that the risk/reward ratio is somewhat out of balance.

I’ve said in previous newsletters that I wouldn’t want to see this bull market grow more than 10% from now until the end of the year. But given the high valuations, a bear market could send us into a steep downturn.

As an interesting aside, the second year of a US President’s term has historically averaged the lowest growth of all four years. And we’re approaching such a year in 2026.

So what can we do?

Studies show that the most successful investors build a portfolio with the amount of risk they’re willing and able to experience in the short-term, and they stick to their strategy through thick and thin, bull and bear. Over long time horizons, these types of investors who don’t attempt to time the market perform best overall.

But that’s easier said than done. And some investors prefer to dynamically manage their portfolio based on market forecasts, if it gives them greater comfort as well as the possibility (though not necessarily likelihood) of outperforming markets in the long-run.

Dynamic portfolio managers might consider the following:

• Large quality stocks that pay high dividends

• Large value stocks with a lower-than-average standard deviation (for reference, the 3- and 5-year S&P 500 standard deviation is around 16)

• Buffer ETFs

• Broad diversification both domestically and internationally across developed nations (particularly those countries included in the MSCI World Index).

• A greater allocation to high quality bonds (investment grade and government)

*Disclaimer: This communication is for informational and educational purposes only and does not constitute personalized investment advice or a recommendation. All investment strategies carry risk, and past performance is not indicative of future results. You should consult a qualified and licensed financial professional — myself or another — regarding your specific situation before making any investment or financial decisions.

While I don’t foresee an impending bear market, modest precautions could be strategically sound based on the mixed signals we’re currently seeing.

In the end, it’s not so much about timing the market as it is about time in the market when it comes to successful investing. But just being mentally prepared for what may come helps us prepare ourselves in such a way that we can remain confidently positioned through all market environments.

Daniel Lancaster, CFA

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