Anatomy of a bear market

Until the tenuous turnaround at the end of October 2002, the bear market that had hammered investors during the previous two years was, by most typical measures, the worst since the Great Depression.

The S&P 500 remains down by more than a third over the past three years, and many investors are still wary.

But a closer look at the index reveals some surprises.

Most investors know that the biggest drops occurred in the information technology and telecommunications sectors. Companies valued at more than $50 billion suffered disproportionately as well. What most people don't know, however, is that the post-bubble damage was confined largely to these categories. While the S&P was plunging, the share prices of almost two-thirds of the companies in it either rose in value or fell by less than 10 percent on an annualized basis.

There is no denying that investors were hurt, but it is a strange bear market when more than 40 percent of the stocks in the index increase in value. What is more, share prices in the information technology and telecommunications sectors now seem to be back in line with the rest of the market, suggesting that the worst of the decline could be over.

Investors have had good reason to be sour: From January 2000 through October 2002, the S&P 500 index fell in value by 37 percent. Yet many investors don't realize that the structure and design of an index can enormously affect their perceptions of the market as a whole. The S&P is value weighted, which means that bigger companies have a greater impact on its performance. If it used an unweighted average (in which each company has the same weight regardless of size) or tracked the performance of the median company, it would have fallen by very little during the same 34 months.

A look at individual companies rather than the aggregate reveals the surprising fact that the value of the shares of 41 percent of the S&P 500 companies actually rose. The shares of an additional 19 percent of the companies in the index declined in value by less than 10 percent on an annualized basis.

There is no denying that investors were hurt, but it is a strange bear market when more than 40 percent of the stocks in the index increase in value.

Maybe this isn't a bear market but rather a large sector correction. The shares of the bubble sectors--information technology and telecommunications--are down by 64 percent and 60 percent respectively, but all others are down only slightly or up.

A second factor that shaped the bear market was the performance of large companies. Since the S&P 500 is a value-weighted index, it is more a market aggregate than an average, and the largest companies have the biggest impact.

Unfortunately, the emergence of mega-capitalized stocks--companies whose market capitalization surpassed $50 billion--during the two-year bubble distorted market averages. The bear market has now delivered a large correction in the values of these very large companies, as it did with the information technology and telecom sectors.

Tallying the damage
Of the 37 percent decline in the S&P 500 from January 2000 through October 2002, 25 percentage points can be attributed to IT and telecom companies. An additional 9 resulted from the decline of some of the largest large-cap stocks. Only 3 of the 37 points were linked to the other 378 companies in the index.

While the shares 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 the downturn in mega-cap stocks. Alternative measures of the performance of the S&P 500 produce a distinctly less dramatic picture of its bear market plunge. In the past it would have made little difference in the end whether the S&P's performance was measured as a weighted index or as an average or a median, but today it is quite a different matter. Measured as an average or a median, the S&P declined relatively little during the bear market.

Maybe this isn't a bear market but rather a large sector correction.

From a historical perspective, it is reassuring that much of the market's excess already appears to have been wrung out. The overall valuation level is in line with history, and a review of the market's price-earnings ratio levels during the past 40 years suggests that the gap between the P/E of the official S&P 500 and the P/E of the median S&P 500 has mostly dissipated.

Back to reality
The brutal correction in the value of the shares of so many companies during the past two years might have restored more realistic levels after a period of overvaluation. Before the emergence of the bubble market, in 1998, information technology and telecom stocks represented 15 percent to 25 percent of the overall market capitalization of the S&P index. By 2000, however, they had soared all the way to 45 percent. Since then, they have pulled back to within their historical range--a level just below their pre-bubble average. Has the market overcorrected in these sectors? We can't say. But we do think it unlikely that their market value will continue to swing widely.

Moreover, the shares of companies with larger capitalizations have also lost their bubble-era premium over the rest of the market--a logical development, since they grow no faster over the long term. And if the bear market, despite the real pain it has inflicted on investors, represents more the bursting of a sector bubble than a symptom of broad economic weakness, in the end the market might show that it is not ailing as badly as it has seemed to be.

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