Anatomy of a bear market

A bear is a bear is a bear, right? That may depend on how you look at it.
Timothy M. Koller and Zane D. Williams

hough global stock markets seemed to

enter autumn showing signs of a new resilience, it would take a dramatic late turnaround to keep 2002 from marking the third consecutive year of decline in the S&P 500 index. Indeed, by most typical measures the worst bear market since the Great Depression took the index down 37 percent from January 2000 through October 2002, savaging portfolios and the retirement accounts of millions of investors. But make a closer examination of this difficult market and the bears contours might surprise you. For example, as the S&P was plunging, were individual company stocks following suit? Not exactly. The fact is that over 40 percent of the companies in the index actually saw their share price increase during this bear market (Exhibit 1). Indeed, while the overall index plummeted the share prices of over 50 percent of S&P 500 companies either increased in value or declined by less than 10 percent. The markets damage to investors may have been all too real, but clearly, it is a bear of a different color when only half of stocks decline more than 10 percent. So how healthy is the market now? We make no forecasts, but working from some additional facts and insights it is possible to view the markets decline as more narrowly based than broad based and to find some historical reassurance that much of its excess has been wrung out.

Exhibit 1. Forty-one percent of S&P 500 have had positive returns

Shareholder returns1 Percent of S&P 500 50% 40% to 50% 30% to 40% 20% to 30% 10% to 20% 0% to 10% 0% to 10% 10% to 20% 20% to 30% 30% to 40% 40% to 50% 50%
1

1% 0% 2% 41% 5% 16% 17% 19% 13% 8% 5% 5% 7%

Jan 1, 2000 to Oct 31, 2002 Does not add up to 100% due to rounding

Source: Compustat, McKinsey analysis

A one-two punch
For starters, a sector-by-sector analysis shows that the markets travails appear to have been highly concentrated in two areas, information technology and telecommunications. Technology and Telecom are down 64 and 60 percent, respectively, but across the broad economy all other sectors are either up or down only slightly (Exhibit 2).

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Exhibit 2. Bubble sectors have performed the worst

Average returns, Jan 1, 2000Oct 31, 2002 Sector Consumer discretionary Consumer staples Energy Financials Health Care Industrials Information technology Materials Telecom Utilities Overall sample Source: Compustat, McKinsey analysis 3 60 2 64 10 7 12 19 Returns, percent 4 21 Number of companies 87 34 25 75 29 44

Exhibit 3. Largest companies have had worst returns

Average returns, Jan 1, 2000Sept 30, 2002 Market cap $ Billions Returns, percent Number of companies

>$50

37

49

$25$50

33

46

$1025 68 75 37 10 36 500 Total Sample <$5

19

110

$5$10

138

23

157

500

Source: Compustat, McKinsey analysis

The brutal correction in the values of many companies in these two sectors may well bring them back to more realistic levels after a period of overvaluation.1 Before the 1998 emergence of a market bubble, technology and telecom stocks typically represented 15 to 25 percent of the S&P indexs overall market capitalization. By 2000, however, they had grown to represent 45 percent of the market. They have since pulled back within their historical range, to a level just below their pre-bubble average. Has the market overcorrected in these sectors? We cannot say. But we do believe it is unlikely that these sectors will continue to see big swings in market value. A second factor that shaped this bear market and the way it was perceived was the performance of the largest companies in the

index. To serve as a better reflection of the underlying economy and its most important business sectors, the S&P 500 was designed as a value-weighted index in which each stocks market value determines its weighting. The result reflects more of a market aggregate than an average, one in which the largest companies have the biggest impact on the index. The two-year market bubble saw the emergence of megacapitalized stocks, which are those stocks whose companies market capitalization surpassed $50 billion during that period. These megacapitalized stocks were largely responsible for the distortion of market averages. As with the technology and telecom sectors, the bear market has delivered a large correction in the values of these very large companies (Exhibit 3).

Anatomy of a bear market | 7

Exhibit 4. How much has the market fallen?

1.4 Unweighted return 1.3

1.2

1.1

Median return

1.0 S&P 500 0.9

0.8

0.7

0.6

0.5 Jan 2000 Mar 2000 May 2000 Jul 2000 Sep 2000 Nov 2000 Jan 2001 Mar 2001 May 2001 Jul 2001 Sep 2001 Nov 2001 Jan 2002 Mar 2002 May 2002 Jul 2002 Sep 2002

Source: Compustat, McKinsey analysis

Exhibit 5. Are S&P 500 P/E ratios back to normal?

30

25

20

S&P 500 Overall

15

10 Median S&P 500 company 5

0 1962

1964

1966

1968

1970

1972

1974

1976 1978

1980

1982

1984

1986 1988

1990

1992 1994

1996 1998

2000 2002 YTD

Source: Compustat, McKinsey analysis

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One effect: while the performance of most companies may continue to hum along, general perceptions of the market have been shaped by the weighting of the index, which is still struggling to recover from the high-tech bubble and downturn in megacap stocks. In fact, alternative measures of the S&P 500s performance produce a distinctly less dramatic picture of its bear market fall. Historically, for example, there has been little difference in the end result when the S&Ps performance is measured as a weighted index; as an unweighted average, in which each company has the same weight regardless of size; or as the result of tracking the median company. Today, however, using either alternative measure produces a picture of an S&P500 that declined little during the bear market. (Exhibit 4). To quantify the impact of the various factors that contributed to the S&Ps decline, 25 percentage points of the markets 37 percent decline can be attributed to IT and telecommunications companies. Another 10 percentage points can be assigned to the decline of very large cap stocks. Only 2 percentage points are due to the other 378 companies in the index (Exhibit 6).

Exhibit 6. The overall result

Shareholder returns, Jan 1, 2000Sept 30, 2002, percent Companies Information Telecom- with market technology munications caps above sector sector $50 bn

All other companies

Total

21 4

10 2 Number of companies 37

77

12

33

378

500

Market cap weight at 27% beginning of period

7%

35%

31%

Source: Compustat, McKinsey analysis

Forward to the past?

From an historical perspective, there may be grounds for reassurance that much of the markets excesses appear to have been wrung out. Indeed, the overall valuation level of the market is in line with history and a review of the markets price to earnings (P/E) levels over the past 40 years suggests that the gap between the P/E of the official S&P 500 and the median P/E mostly dissipated (Exhibit 5).

This means that larger capitalization companies have lost their bull-market premium over the rest of the market, a logical development since they dont grow faster over the longer term. And if the bear market, despite the real pain it inflicted on investors, represents more the bursting of a sector bubble than the outgrowth of broad economic weakness, in the end the market may demonstrate that it is not ailing as badly as it has seemed to be. MoF
Tim Koller (Tim_Koller@McKinsey.com) is a principal in McKinseys New York office. Zane Williams (Zane_Williams@McKinsey.com) is an associate in the Washington, D.C. office. Copyright 2003 McKinsey & Company. All rights reser ved.
1

Timothy M. Koller and Zane D. Williams. What happened to the bull market? McKinsey on Finance, Number 1, Summer 2001.

Anatomy of a bear market | 9

McKinsey on Finance is a quar terly publication written by exper ts and practitioners in McKinsey & Companys Corporate Finance & Strategy Practice. It offers readers insights into value-creating strategies and the translation of those strategies into stock market performance. This and archive issues of McKinsey on Finance are available on line at http://www.corporatefinance.mckinsey.com

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