THE BLOG
01/16/2009 05:12 am ET | Updated May 25, 2011

History of Market Recoveries

It is natural for investors to be concerned when the market is in "bear mode" and their portfolio declines. Fear of further declines and volatility make investors skittish, and the instinctive reaction is to pull money out of the market, trying to stem the losses.

It might help to get some insight into how the stock market behaved in previous bear markets, defined as a period in which stock indices fall 20% or more (that usually happens when the economy is in recession, and unemployment and/or inflation are high).

Historically, bear markets are followed with powerful rallies. According to Prudential Investment Management, in the past nine bear markets (going back to the 1950's), when the market declined substantially as the economy contracted, the average first year recovery saw a 36% return. The following year showed a 12% average return.

For example, the recession of 1973-1974, triggered by the oil embargo and quadrupling oil prices, and coupled with the Watergate scandal, the Nixon resignation and Vietnam War spending, had the country in a very gloomy mood. People anticipated the worst and spoke of the end of the American era. The following year, the Dow Jones Industrial Average climbed 38%, and the year after that an additional 21%. The steep '81-'82 declines brought about by the massive failure of the savings and loans industry and high interest rates aimed at choking inflation, was followed by a 58% first year recovery. In October 2002, the market indices bottomed after the collapse of the great tech bubble, and in the wake of the terrorist attacks of September 11th, concurrent with corporate scandals such as the bankruptcy of Enron. The following year saw a 34% rise in the S&P 500.

In addition, stock market declines typically start before a recession begins, and end much before it. In fact, in all cases observed in the last sixty years, without exception, by the time a recession ends, the market has already rebounded to much higher levels off the bottom. The most pessimistic period economically has been the best time to buy stocks. For example, the S&P 500 bottomed in 1974, although the recession lasted until March 1975. It bottomed in 1990 even though the recession lasted until March 1991. There are many more examples.

We are in a recession right now. People are panicked and markets have seized up, especially credit markets. But almost every country in the world is addressing the financial and economic crisis. The bailouts, stimulus packages, liquidity facilities, central bank interventions, and regulatory reforms will have an impact in due course. Banks will eventually recapitalize and clean their balance sheets and then they will want to start generating profits again. In order to create revenue from the hundreds of billions that have been given to them, they will start lending. Investors will reject government bonds with negative real return and demand higher yields. Attention will shift from capital preservation to profits.

If you have a long term approach and are not leveraged, and as long as you buy shares of companies with strong balance sheets and with durable competitive advantage, then this is the opportunity of a generation. And there are large numbers of companies that are credit worthy, with strong balance sheets and no need to access credit, and they are available at bargain prices.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.