Learnings from Market Crashes Across 68 Countries and ~1900 Years of Data May 2019

By: Maneesh Shanbhag, CFA

Summary

• We studied almost 1900 years of equity markets data across 68 Developed, Emerging, and Frontier countries • On average across countries: o Smaller corrections of 10-30% occur every 2-4 years, and recover within months o Big crashes of 40% or worse occur on average every decade, and recoveries can take 5- 10 years or longer • The two main causes of market crashes are debt crises and bubbles; these are the events investors need to prepare for to avoid permanent loss • Crashes tend to be global, so all markets are affected. Global diversification does not reduce exposure to this risk. Diversification within equities is overrated while diversification across asset classes is under utilized

Introduction Investing is risky, but all risks are not the same. We think investors are overly fearful of the ups and downs in markets. Most of this volatility is just noise where prices recover quickly. The big market crashes are caused by economic crises and therefore can take many years to recover from. This paper is a study of both shallow and deep market drawdowns and what investors should do about each one.

Many people consider the daily price movements (i.e. volatility) of publicly traded assets as risk. This risk is temporary, and it is significantly less important than the risk of permanent loss, which can change the trajectory of your returns forever. For this reason, we are most concerned about the risk of permanent losses and think most investors should be, too. And in public equity markets, this is caused by the big drawdowns of -40% or more, which often take years or even decades to recover from.

It’s interesting to note upfront that long periods of flat returns, which erode investor purchasing power over time, never happened without a big crash in stock markets. Some investors choose to trade, hedge, or time these events, often through strategies with high fees or that earn no long-term return. However, instead of helping to avoid the crashes, these strategies often guarantee this type of permanent loss. One example is private equity which has a high risk of permanent loss from leverage and high fees (6-7%1), but without any of the temporary losses from wiggles in daily prices like stock prices.

By applying the learnings from our research, overlaid with logic and common sense, we hope to provide a more effective investment approach to protect against these crashes and permanent losses.

A study across time and place After the 20% dip in the last Fall and seeing investors panic for the first time in many years, we wanted to measure how often real panics occurred historically. We studied the local currency stock market returns across 68 developed, emerging and frontier countries, ranging from Canada to China to Colombia and Kenya. For most developed markets, data starts in 1970 (49 years each) and with US data

1 https://www.regjeringen.no/contentassets/7fb88d969ba34ea6a0cd9225b28711a9/evaluating_doskelandstromberg_10012018.pdf

Greenline Partners, LLC New York · Seattle 1 starting in 1926. Most other countries have data back to 1998 but sometimes less. In total, we analyzed 1878 years of individual country stock market returns for crashes of various sizes. A table in Appendix A shows each market we studied and details for each index.

We present three learnings from this study that we hope is useful to investors:

1. The frequency and length of drawdowns of various sizes. We measured this for all markets, and hope the findings are useful ahead of the next downturn in global stock markets.

2. Understanding the causes of the big crashes - drawdowns of -40% or more and which took at least 3 years to recover from.

3. Ways investors can prepare for crashes. We note some general observations about different ways to diversify and their effectiveness.

Why the big crashes matter and the rest should be ignored A true market crash is different than ordinary wiggles. They have only a few catalysts that do not precede typical market dips – debt crises and the bursting of bubbles. Our former colleagues at Bridgewater Associates have written in depth about the mechanics of these economic crises and we encourage you to review their materials2.

To illustrate the difference between crashes and other market dips, we show a chart of the peak-to-trough drawdowns for the US stock market back to 1926. There were only 4 instances of drawdowns -40% or worse over this period (5 if you count the crash of 1937) but many smaller dips. That’s less than one crash every 20 years, and only ~2 crashes during an average investing lifetime. Furthermore, the US stock market recovered from all these crashes.

US stock market drawdowns since 1926

0% -10% -20% -30% -40%

-50% Down -40% or worse Drawdown -60% -70%

-80% Source: Bloomberg, Ken French Data Library

This can make it seem like crashes are not events to worry about, and that buying and holding the market is the best long run strategy. However, our experience in the US has been somewhat unique, and not all markets have been so fortunate. We have a diversified economy and the most developed capital market in the world, combined with some historical luck that may not repeat.

2 https://www.principles.com/big-debt-crises/

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The charts below show some of the other markets that have gone 10, 20, even 30+ years without fully recovering. It is noteworthy that Japanese markets have still not recovered from their asset bubble and resulting debt crisis of 1989. As we will see, this crash was caused by all the specific drivers of big crashes.

Japan - 30 years into recovery Greece - Still down 90+% since 2008 1969 1978 1987 1996 2005 2014 1998 2003 2008 2013 2018 0% 0%

-20% -20% -40% -40% -60% Drawdown Drawdown -60% -80%

-100% -80% Italy - 10+ years into recovery Finland - ~20 years since Dot.com 1989 1994 1999 2004 2009 2014 1987 1992 1997 2002 2007 2012 2017 0% 0%

-20% -20%

-40% -40% Drawdown Drawdown -60% -60%

-80% -80% Source: Bloomberg, Greenline Partners analysis

Suppose, as a US investor, you don’t believe we will ever experience a crash from which we will not recover. Is there still a reason to care about these crashes? Yes, because crashes contribute to long periods of low returns which erode purchasing power and increase the odds that you won’t reach your financial goals.

The chart below shows rolling 10-year returns for the US. We can see that all the 10-year or longer periods of low returns coincide with a big crash.

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US over rolling 10-yr periods 25%

20% Coincides with 15% crashes of 1929, 1937 and Great 10% Depression 5%

Return, annualized 0% Coincides with Nifty -5% Fifty crash (1973) Coincides with Dot.com (2000) and subprime (2008) crashes -10%

Source: Bloomberg, Ken French Data Library

Crashes cause investors to panic. They change future investor behavior as well as regulations and policies of central banks. Most investors, often because of the structure of their portfolios, are not able to hang on during a crash and it’s this selling pressure that turns the dip into a big crash, leading to losses. For institutions and retirees with regular cash needs, these sizeable drawdowns are an unacceptable outcome.

Corrections vs crashes: Understanding the differences, frequencies and recovery times We analyzed stock market returns in 68 countries and counted all the drawdowns of various sizes and then attempted to understand the drivers of every crash worse than -40%, over 125 in total.

Market Corrections: Frequent with short recoveries

We find many investors fear even small ups and downs (the popularization of trading by the media is certainly no help), so we review smaller corrections of at least -10% to crashes of -40% or more. The table below summarizes the average frequency that these drawdowns occur across Developed, Emerging, and Frontier markets. The main takeaways are:

• Equity markets, on average, have fallen -10% or more only every 2-3 years • “Corrections” of -20% have occurred about once every 4-5 years (most recently in the US in 2011 and 2018). Almost half of these bear markets are big crashes that happen about every 10-20 years. • ”Crashes” of -40% or more, are relatively infrequent.

Frequency (years) Developed Emerging Frontier Drawdown <-10% 2.8 1.9 2.3 Drawdown <-20% 5.4 3.9 4.3 Drawdown <-30% 9.3 6.7 7.3 Drawdown <-40% 14.8 10.7 9.9 Source: Bloomberg, Greenline Partners analysis

The table below summarizes the recovery times from Corrections (-30% drop or less) compared to larger drawdowns. The average recovery time from drops up to -30% is barely a year, whether talking about Developed, Emerging, or Frontier markets. Crashes on the other hand take multiple years and sometimes decades to recover from.

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Recovery Time (months)3 Developed Emerging Frontier Correction (drawdown up to -30%) 14 9 10 Crash (drawdown worse than -30%) 70 55 94 Source: Bloomberg, Greenline Partners analysis

We think the frequency and recovery time statistics are extremely useful. You can see that, on average, recovery from smaller corrections in market prices takes months, not years. Given this reality, we believe investors would benefit from largely ignoring the onslaught of daily news, which is filled with fear and anxiety-producing noise. The best strategy is not to time these corrections, but rather to buy and hold through them. Most often when investors try to time them, they either sell too low or buy back too late, resulting in worse performance than if they had simply been patient and waited for the recovery to occur.

We do see that big crashes occur roughly every decade and can take 5+ years to recover from. We discuss these next, what causes them, and how to prepare.

The big crashes: Depth and time to recover makes them different

From looking at the statistics for big market crashes, even if you have never personally experienced one, one can immediately understand why they can be so damaging to portfolios. And this is before even considering the psychological toll and impact to governance of institutional investors. We think understanding the drivers of these crashes can help investors prepare for these events, without having to predict the future. First, its important to see how common it is for stock markets to endure crisis and not recover for 10+ years. The table below lists each country, by Developed, Emerging, and Frontier bucket, that has not yet recovered from a crash at least 10 years ago. It also shows what percentage of each bucket these countries represent. We find that 28% of the markets we studied have not yet recovered from a crash over 10 years ago, and in some cases much longer. We can see that developed markets are not spared from this fate, with Japan being the most notable. Please see Appendix B for more details on how we classified each crash and why we think the buckets are more important than our classification.

# Not Yet List of Countries Markets Recovered Developed 6 of 23 (26%) Japan, Austria, Finland, Ireland, Italy, Portugal Emerging 3 of 24 (13%) Czech Republic, Greece, UAE Frontier 10 of 21 (48%) Croatia, Serbia, Slovenia, Morocco, Nigeria, most of Middle East Global 19 of 68 (28%) Source: Bloomberg, Greenline Partners analysis

One might look at this table and ask how it is fair to compare the fate of the Serbian stock market to that in the US. The Serbian index used contains only 2 stocks with a total market value of $200 Million (not Billion). In comparison, the US index used (MSCI USA) contains 622 stocks and a market cap 100 times greater and almost no single companies as small as the entire Serbian market. We agree that they are not comparable. Many studies use comparisons across disparate countries to justify excessive geographic diversification. We discuss this point in the next section to show why geographic diversification is of little benefit, especially for investors residing in larger developed markets.

3 It is noteworthy to compare the statistics for developed versus smaller markets, as the table would make it appear that less developed markets recover more quickly. One reason for the counterintuitive difference is that data for developed markets starts in 1970, whereas most emerging markets start in 1999 or later. The earlier years had more economic volatility (Nifty Fifty crash, oil embargo, delinking currencies from gold, high interest rates, high inflation, etc…) resulting in more stock market volatility and longer recovery times.

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Geographic diversification within the equity market is overrated One observation from this study is that diversification within the global equity market is overrated. And this observation is very informative to portfolio construction. When we combine this observation with basic portfolio math, which shows that equity portfolios are adequately diversified with only 10-20 holdings, we have powerful support for simplified portfolios. Yet most investors hold hundreds and thousands of positions, presumably to achieve “adequate diversification”.

First, there is little diversification benefit from going international when it comes to mitigating the impact of market crashes. And this applies to local investors in all countries with diversified and developed capital markets.

Economic crises tend to be global in nature. The US subprime crisis almost took down the entire global financial system. The Dot.com crash brought down global equity markets. All markets tend to draw down together, especially during the big crashes. The chart below shows how markets historically crashed together and to similar levels.

All markets drawdown together 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 0%

-10%

-20%

-30% Drawdown -40%

-50%

-60% US Developed ex-US Emerging

Source: Bloomberg

Going international does not in a meaningful way mitigate risk to economic crisis or stock market crashes. Therefore, we argue that the only reason to look at foreign markets is the pursuit of additional return.

Second, the data also validates the theory on the number of positions for adequate diversification. Many of the country indices we studied contained fewer than 10 positions (e.g. Austria, Ireland, New Zealand, etc...). Despite the difference in number of holdings, most indices lost similar amounts and recovered in the same amount of time during crashes, showing that very few positions are required to achieve an adequately diversified equity portfolio.

Concentration risk is still real While we have just laid out our view on the flaws with the traditional practice on diversification, concentration risk is still real. There are many cases where small markets have not yet recovered from recent crashes, in part because they were overly exposed to a single large stock or sector. We will highlight a few, but all of

Greenline Partners, LLC New York · Seattle 6 them illustrate that concentration alone is not the issue. Rather it is concentration combined with exposure to a bubble or debt crises that leads to especially painful crashes.

Finland

First a study of the Finnish equity market. The MSCI Finland Index contained only 12 stocks as of Dec 2018 and has not yet recovered from the Dot.com crash almost 20 years ago. The issue for Finland was that Nokia grew to become almost 50% of the index at the peak of the Dot.com bubble. When tech stocks crashed, so did Nokia, bringing Finland’s market down almost 80% as we see in the chart below. This requires a 500% return to reach break-even again, a level this market has not yet achieved.

Finland: Nokia and Dot.com Crash 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 0% -10% -20% -30% -40% -50%

Drawdown -60% -70% Nokia was almost -80% 50% of the index -90% before falling 90%

Source: Bloomberg

The solution to avoiding the permanent loss of the Finland disaster was avoiding an overvalued bubble stock. Broad geographic diversification would have also helped but all markets fell 40+% during the Dot.com crash.

Ireland

Next, we look at the example of Ireland during the global financial crisis of 2008. Ireland has become a financial hub in Europe, in part due to their light regulations and favorable tax laws. As a result, through the mid 2000’s, Irish banks grew as did the Irish financial sector, becoming a hub for hedge funds and corporate tax headquarters alike. A small handful of Irish banks grew to become >60% of their equity market heading into the Global Financial crisis. As a result, when the crisis took down many banks, the Irish equity market fell -80% and is still down -60% from its high over 10 years ago shown below.

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Ireland: Irish banks and Global Financial Crisis 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 0% -10% -20% -30% -40% -50%

Drawdown -60% -70% Irish banks >60% -80% of index, before -90% falling 80+%

Source: Bloomberg

Thoughtful diversification is key to surviving economic crises and the resulting equity market crashes, but as we have shown, geographic diversification is not the answer. Then what should investors do?

How to prepare for big crashes As discussed, the two biggest drivers of equity market crashes are debt crises and bubbles and their causes need to be addressed independently in a portfolio. Furthermore, each of these events can invoke different types of pain.

Avoid bubbles

Bubbles tend to be isolated and are possible to spot and therefore avoid, assuming one doesn’t get caught up in the emotions of a run-up. The Dot.com bubble and crash was largely isolated to the technology sector, with relatively small leakage effects to other parts of equity markets. When we categorized each individual historical bubble, they all tended to be concentrated in a few equities or sectors. Japan’s bubble in the late 1980’s was primarily in real estate (which required loads of borrowing), but also in some of their equity market sectors. Sweden and Finland had bubbles in the late 1990’s due to a few technology stocks like Ericsson and Nokia. Going back further, had the Poseidon bubble in 1970 (a single nickel mining company) and Singapore had the Pan-Electric Industries, a conglomerate, crash in 1985.

One can argue that bubbles are not easy to avoid. In which case diversification as described in the next section is the answer. We would argue that euphoria around an asset shows enough signs. Bitcoin and the in 2017 is only the most recent example that many spotted in spite of there being no way to value this asset. Avoiding bubbles requires mostly patience and the ability to resist the temptation to chase short-term gains as the bubble runs higher.

Diversify to debt crises

Debt crises are harder to deal with. Debt crises are hard to spot and impossible to time. Debt levels around the world have grown to levels previously unimagined. Yet aside from 2008, this has hardly caused an issue. Some prognosticators had been calling for a depression since the 1970’s but had to wait 30 years to be proven correct. The chart below shows current US government debt as a percent of GDP over the last 80 years. It has only climbed higher since 2008.

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US Government Debt as % of GDP 140%

120%

100%

80%

60% % of GDP 40%

20%

0% 1939 1949 1959 1969 1979 1989 1999 2009

Source: US Federal Reserve

We expect a debt crisis to return in the future but we do not know when. We also do not know if it will be deflationary (if managed poorly), inflationary (if managed better), or either. Without the ability to predict which way it may unfold, the best thing to do is prepare.

Debt crises can be deflationary or inflationary, so we need to prepare for both outcomes

As Ray Dalio and Bridgewater have written in “Principles for Navigating Big Debt Crises”, the domino effect created by debt crises is typically deflationary, but they can also become inflationary through the devaluation of currency. Deflation and inflation drive asset classes differently, giving potential for fundamental, reliable diversification.

Severe deflations are the worst environment for equities because of the reduced spending and decline in available credit that define these periods. This causes sales and profits to fall precipitously, driving down stock prices. Inflations are painful for equities too, but less so for globally diversified businesses that benefit from the spurt in sales growth from the lowered price of exports. Businesses can also pass through higher costs to varying degrees.

In deflationary debt crises, interest rates tend to fall in nominal terms. In such an environment, the safe- haven assets are cash and government bonds of the safest countries. Gold too, a safe-haven, successfully played this role in the 2008 financial crisis as it rose as central banks embarked on quantitative easing (money printing). While timing and forecasting are fraught with risk and often wrong, thoughtful diversification informed by understanding fundamental drivers is low risk and low cost.

Below, we show the rolling 3-year excess returns over cash of Treasury bonds to equities, highlighting the crash periods of 2000 and 2008. We can see government bonds delivered positive returns, especially when equity markets fell the most.

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Gov't Bonds protect against Equity Crashes 30% (rolling 3-yr returns) 25% 20% 15% 10% 5% 0% -5% -10% Annualized Return -15% Treasury bonds Stocks -20% up in 2000 and Gov't Bonds 2008 crashes -25% 1996 1999 2002 2005 2008 2011 2014 2017

Source: Bloomberg

And next we show the rolling 10-year excess returns over cash of gold versus equities during the inflationary 1970’s. Gold and other commodities have served as a reliable diversifier in times of high and rising inflation.

Gold is a reliable diversifier to drivers of crisis (rolling 10-yr returns) 40% Stocks 35% Gold 30% 2008 debt 25% crisis 20% 15% 10% 5% 0% Annualized Return -5% -10% Dollar delinked from -15% gold = high inflation 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 2018

Source: Bloomberg, Greenline Partners analysis

This is not meant to be a sales pitch to go out and buy bonds and gold today but rather to inform how to think about preparing for financial crises. We have presented but two simple solutions that should work in the next crash.

Prepare for crashes by diversifying to their causes After a study of this magnitude, one would expect many different conclusions, but there are not. The most important by far is that everyone must prepare for market crashes to avoid the risk of permanent loss. Preparing is key, rather than predicting, which is fraught with difficulty.

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The second big conclusion is that normal market volatility should be ignored and the best solution is to buy and hold through these periods. Markets frequently fall up to -30% with relatively rapid recoveries. Timing these periods is even harder than for the big crashes.

Bubbles can be avoided with the right investment temperament and governance, though diversification is an effective and low risk solution here. Debt crises on the other hand need to be prepared for. Diversification across geographies is practiced by most investors but it is the least impactful. Most investors not only hold many securities in their home market but are further diversified across many countries and multiple managers. This type of overdiversification guarantees near average results, which is often not the goal. Instead, diversification is more effective across disparate asset classes that respond fundamentally differently to shifts in growth and inflation.

From the data studied, it appears obvious to us which events investors need to prepare for – bubbles and debt crises, which can turn deflationary or inflationary. Simply knowing this is more than half the battle to being prepared in this notoriously uncertain world.

Our work may lead even more investors to attempt what they are already doing – to forecast and attempt to time bubbles and debt crises. Said another way, effectively playing hot potato with their money where the odds of success are not in their favor. In contrast, based on our research, the high probability game of always being prepared for these events is the best solution.

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Appendix A: List of Equity Markets Studied

Total Market Country Constituents Cap ($B) Years of Data Major Developed Markets Australia 69 864 49 Canada 91 1,196 49 France 79 1,387 49 Germany 64 1,101 49 Hong Kong 47 488 49 Japan 322 3,074 49 Switzerland 38 1,080 49 United Kingdom 96 2,115 49 United States 622 22,073 91 Small Developed Markets (<$500bln mkt cap or <20 stocks) Austria 6 30 49 Belgium 10 119 49 Denmark 17 218 49 Italy 23 282 49 Netherlands 19 429 49 Norway 10 91 49 Singapore 25 171 49 Spain 22 387 49 Sweden 32 339 49 Finland 12 130 31 Ireland 8 68 31 Israel 11 67 26 New Zealand 7 29 31 Portugal 3 20 31 Major Emerging Markets Brazil 53 360 20 Mexico 26 134 20 Russia 23 179 20 South Africa 49 300 20 China 459 1,462 20 India 78 451 20 Indonesia 28 111 20 South Korea 115 662 20 Malaysia 44 117 20 Taiwan 86 548 31 Thailand 36 117 20 Small Emerging Markets (<$100bln mkt cap or <10 stocks) Chile 17 52 20 Colombia 9 20 20 Peru 3 21 20 Czech Republic 3 8 20 Egypt 3 6 20 Greece 6 10 20 Hungary 3 16 20 Poland 20 60 20 Turkey 18 30 20 Pakistan 3 2 20 Phillipines 23 54 20 Qatar 10 53 13 United Arab Emirates 10 36 13 Frontier Markets (MSCI Frontier Markets Index) Argentina 14 22 20 Croatia 4 2 17 Estonia 2 1 17 Lithuania 2 0 11 Kazakhstan 2 1 14 Romania 5 4 14 Serbia 2 0 11 Slovenia 2 2 17 Kenya 4 6 17 Mauritius 1 2 17 Morocco 11 9 20 Nigeria 12 7 17 Tunisia 2 1 15 Bahrain 5 5 13 Jordan 3 1 20 Kuwait 9 26 13 Lebanon 4 3 17 Oman 5 2 13 Bangladesh 5 3 10 Sri Lanka 2 1 20 Vietnam 16 18 13

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Appendix B: The Drivers of Market Crashes

To understand the drivers of crashes, we analyzed the economic catalysts of every crash (drawdown worse than -40%) in every Developed and Emerging market going back as far as reasonable data would permit. We excluded Frontier markets here because their data history tended to be too short and so most only experienced the global financial crisis. This still left 47 countries, ~1500 years of data, and over 125 stock market crashes to study.

The table below shows a list of the drivers of crashes and list of global stock market crashes that we bucket into each category. One may not agree with how we classified each crash, but our conclusion from this study is the list of drivers of crashes – debt crises, bubbles, and government intervention – is undisputable. If one can understand the common causes of stock market crashes, then one can prepare for them.

Crash Type Examples of crashes of this type Bubble bursting Dot.com (2000), Nifty Fifty (1973), Oil price crash (2014) Debt crisis – Global financial crisis (2008), Japan asset bubble (1989), Eurozone debt crisis deflationary (2011) Debt crisis – Asian financial crisis (1997), Russian financial crisis (1998), UK crash (1973) inflationary Government Arab Spring (2010), China privatizes some sectors (1999) driven Concentration South America commodities (Chile, Colombia, Peru, 2014), Middle East oil (Qatar, UAE, 2014), Irish banks (Ireland, 2008), Ericsson (Sweden, 2000), Nokia (Finland, 2000), Pan-Electric (Singapore, 1985), Poseidon bubble (Australia, 1970) Other Black Monday (1987)

When looking at the crashes that we bucket under Concentration, we can see that it wasn’t just concentration risk that was the problem. For example, the Ericsson and Nokia bubbles were linked to Dot.com and its subsequent crash. Were it not for the overvaluation of these stocks, the local markets in Sweden and Finland may never have crashed and the concentration probably would not have been an issue. However, this does point to the risk of concentrating your exposures too much.

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