Button: view PDF; primary; false; /content/dam/northerntrust/pws/nt/documents/commentary/wealth-management/a-history-of-drawdowns.pdf

The annualized return was 9.6% for U.S. equities and 4.9% for intermediate-term U.S. government bonds from January 1926 to June 2022. These returns compare to an inflation rate of 2.9% over that history. The higher return of stocks came with higher risk – a standard deviation of 18.6% versus just 4.4% for bonds. In addition to lower risk, bond returns were uncorrelated to stock returns (0.05), providing a diversification benefit.

Standard deviation is a good summary risk measure for statisticians, but it is not intuitive to many investors. It manifests through time as stock-market and bond-market drawdowns, which are more intuitive (and painful) representations of risk. We survey a history of market drawdowns, first reviewing nominal stock and intermediate-term government bond drawdowns, then real (inflation-adjusted) stock and bond drawdowns from 1926 to June 2022.¹

Exhibit 1 is a drawdown or “underwater” graph, where each new stock or bond peak value is reset to 0% to focus the eye on drawdowns. The graph shows that equity drawdowns have been far more severe and prevalent than bond drawdowns. In fact, the vast majority of the U.S. stock market’s life (about 94% of the time) has been spent in a drawdown from the prior peak, suggesting that drawdowns are a normal part of the return-seeking process.

EXHIBIT 1: STOCKS AND BONDS UNDERWATER

^{1 We use monthly total returns of the Ibbotson US Large Cap Stock and US Intermediate-Term Government Bond indexes to March 1994, then daily total returns on the S&P 500 and Bloomberg US Treasury indexes thereafter to capture more granular drawdowns when this higher-frequency data became available in Bloomberg.}

In Exhibit 2 we identify seven major equity drawdown events (top panel) and six major bond drawdown events (bottom panel) in reverse chronological order. Each drawdown event begins from its unique prior peak value for either stocks or bonds. The average equity drawdown across the equity drawdown events is -45%, with the largest (-83%) and longest drawdown occurring during the Great Depression. The current Post-COVID Inflation drawdown is the least severe equity drawdown of the group, but it may not be over as of the writing of this article. Importantly, bond returns during these equity drawdowns were almost always positive and uncorrelated (or negatively correlated) with stocks, providing diversification when it mattered most.

The average bond drawdown across the bond drawdown events is -8%, with the largest (-15%) occurring during the current Post-COVID Inflation, which as noted may not be over. Stock returns during these discrete bond drawdowns were usually positive and uncorrelated with bonds, providing diversification.

EXHIBIT 2: STOCK AND BOND DRAWDOWN EVENTS

Investors perceive nominal drawdowns in real time. However, real drawdowns capture the effect of inflation on the purchasing power of stocks and bonds. Given the current inflationary environment, we also review real stock and bond drawdowns.

Exhibit 3 shows that equity drawdowns are just as severe and prevalent when adjusted for inflation. However, strikingly, real bond drawdowns can also be severe and they can persist for decades. The real bond drawdown that began with World War II Inflation and was extended and exacerbated by the 1970s Great Inflation ultimately reached a maximum drawdown of -44%. This event does not even register in the nominal returns of Exhibit 1, but it is more severe than the -25% real bond drawdown for the current Post-COVID Inflation, which may not be over.

EXHIBIT 3: STOCKS AND BONDS UNDERWATER (INFLATION-ADJUSTED)

The drawdown history shows that inflation is an outsized risk to the purchasing power of bonds in particular. This history supports a meaningful allocation to Treasury inflation-protected securities (TIPS), even for taxable investors who may otherwise have a bias for the tax-exempt income of municipal bonds. The small cost of giving up some after-tax yield may be worthwhile when viewing Exhibit 3.

© 2022 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S.

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value. The market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.