6 | McKinsey on Finance Winter 2003

Though global stock markets seemed toenter autumn showing signs of a new

resilience, it would take a dramatic lateturnaround to keep 2002 from marking thethird consecutive year of decline in theS&P 500 index. Indeed, by most typicalmeasures the worst bear market since theGreat Depression took the index down37 percent from January 2000 throughOctober 2002, savaging portfolios and theretirement accounts of millions of investors.

But make a closer examination of this difficultmarket and the bear’s contours might surpriseyou. For example, as the S&P was plunging,were individual company stocks followingsuit? Not exactly. The fact is that over40 percent of the companies in the indexactually saw their share price increase duringthis bear market (Exhibit 1). Indeed, while theoverall index plummeted the share prices ofover 50 percent of S&P 500 companies eitherincreased in value or declined by less than10 percent. The market’s damage to investorsmay have been all too real, but clearly, it is abear of a different color when only half ofstocks decline more than 10 percent.

So how healthy is the market now? We makeno forecasts, but working from someadditional facts and insights it is possible toview the market’s decline as more narrowlybased than broad based and to find somehistorical reassurance that much of its excesshas been wrung out.

A one-two punch

For starters, a sector-by-sector analysis showsthat the market’s travails appear to have beenhighly concentrated in two areas, informationtechnology and telecommunications. Technol-ogy and Telecom are down 64 and 60 percent,respectively, but across the broad economy allother sectors are either up or down onlyslightly (Exhibit 2).

Anatomy of a bear marketA bear is a bear is a bear, right? That may depend on how you look at it.

Timothy M. Koller and Zane D. Williams

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

� 50%

Shareholder returns1

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

Percent of S&P 500

40% to 50%

30% to 40%

20% to 30%

10% to 20%

0% to 10%

�10% to �20%

�20% to �30%

�30% to �40%

�40% to �50%

0% to �10%

� �50%

41%

1%

0%

2%

5%

16%

17%

13%

8%

5%

5%

19%

7%

Source: Compustat, McKinsey analysis

Anatomy of a bear market | 7

Exhibit 3. Largest companies have had worst returns

index. To serve as a better reflection of theunderlying economy and its most importantbusiness sectors, the S&P 500 was designed asa value-weighted index in which each stock’smarket value determines its weighting. Theresult reflects more of a market aggregate thanan average, one in which the largestcompanies have the biggest impact on theindex.

The two-year market bubble saw theemergence of megacapitalized stocks, whichare those stocks whose companies’ marketcapitalization surpassed $50 billion duringthat period. These megacapitalized stockswere largely responsible for the distortion ofmarket averages. As with the technology andtelecom sectors, the bear market has delivereda large correction in the values of these verylarge companies (Exhibit 3).

The brutal correction in the values of manycompanies in these two sectors may well bring them back to more realistic levels after a period of overvaluation.1 Before the1998 emergence of a market bubble,technology and telecom stocks typicallyrepresented 15 to 25 percent of the S&Pindex’s overall market capitalization. By 2000,however, they had grown to represent45 percent of the market. They have sincepulled back within their historical range, to alevel just below their pre-bubble average. Hasthe market overcorrected in these sectors? Wecannot say. But we do believe it is unlikelythat these sectors will continue to see bigswings in market value.

A second factor that shaped this bear marketand the way it was perceived was theperformance of the largest companies in the

Total Sample

<$5 23

$5–$10 4

$10–25 –19

$25–$50

>$50

500–3

157

138

110

46

49–37

–33

Average returns, Jan 1, 2000—Sept 30, 2002

Number ofcompanies

Returns,percent

Market cap$ Billions

Information technology

Industrials

Health Care

Financials

Energy

Consumer staples

Consumer discretionary

Average returns, Jan 1, 2000—Oct 31, 2002

87

Number of companies

Returns, percentSector

Materials

Telecom

Utilities

Overall sample

75

68

44

75

25

34

37

10

36

500

4

–64

7

29

19

–10

–60

2

–3

21

12

Exhibit 2. Bubble sectors have performed the worst

Source: Compustat, McKinsey analysis Source: Compustat, McKinsey analysis

8 | McKinsey on Finance Winter 2003

Jan 2000

Mar 2000

May 2000

Jul 2000

Sep 2000

Nov 2000

Jan 2001

Mar 2001

May 2001

Jul 2001

Sep 2001

Jan 2002

Mar 2002

May 2002

Jul 2002

Sep 2002

Nov 2001

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4Unweighted return

Median return

S&P 500

Source: Compustat, McKinsey analysis

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

5

0

10

15

20

25

30

S&P 500 Overall

Median S&P 500 company

1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002YTD

Source: Compustat, McKinsey analysis

Exhibit 4. How much has the market fallen?

Anatomy of a bear market | 9

One effect: while the performance of mostcompanies may continue to hum along,general perceptions of the market have beenshaped by the weighting of the index, which isstill struggling to recover from the high-techbubble and downturn in megacap stocks. Infact, alternative measures of the S&P 500’sperformance produce a distinctly less dramaticpicture of its bear market fall. Historically, forexample, there has been little difference in theend result when the S&P’s performance ismeasured as a weighted index; as anunweighted average, in which each companyhas the same weight regardless of size; or asthe result of tracking the median company.Today, however, using either alternativemeasure produces a picture of an S&P500that declined little during the bear market.(Exhibit 4).

To quantify the impact of the various factors that contributed to the S&P’s decline, 25 percentage points of the market’s 37 percent decline can be attributed to IT and telecommunicationscompanies. Another 10 percentage points can be assigned to the decline of very largecap stocks. Only 2 percentage points are dueto the other 378 companies in the index(Exhibit 6).

Forward to the past?

From an historical perspective, there may begrounds for reassurance that much of themarket’s excesses appear to have been wrung out. Indeed, the overall valuation levelof the market is in line with history and areview of the market’s price to earnings (P/E)levels over the past 40 years suggests that thegap between the P/E of the official S&P 500and the median P/E mostly dissipated(Exhibit 5).

This means that larger capitalizationcompanies have lost their bull-marketpremium over the rest of the market, a logicaldevelopment since they don’t grow faster overthe longer term. And if the bear market,despite the real pain it inflicted on investors,represents more the bursting of a sectorbubble than the outgrowth of broad economicweakness, in the end the market maydemonstrate that it is not ailing as badly as ithas seemed to be.

Tim Koller (Tim_Koller@McKinsey.com) is a principal

in McKinsey’s New York office. Zane Williams

(Zane_Williams@McKinsey.com) is an associate in the

Washington, D.C. office. Copyright © 2003 McKinsey

& Company. All rights reserved.

1 Timothy M. Koller and Zane D. Williams. “What happened tothe bull market?” McKinsey on Finance, Number 1, Summer2001.

MoF

Shareholder returns, Jan 1, 2000—Sept 30, 2002, percent

Informationtechnology

sector

Number ofcompanies

Market capweight atbeginning of period

Telecom-munications

sector

Companies with market caps above

$50 bnAll other

companies Total

–21

–4

–10–2 –37

77 12 33 378 500

27% 7% 35% 31%

Exhibit 6. The overall result

Source: Compustat, McKinsey analysis

McKinsey & Company is an international management consulting firm serving corporate and governmentinstitutions from 85 offices in 44 countries.

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McKinsey on Finance is a quarterly publication written by experts and practitioners in McKinsey & Company’sCorporate Finance & Strategy Practice. It offers readers insights into value-creating strategies and thetranslation of those strategies into stock market performance. This and archive issues of McKinsey onFinance are available on line at http://www.corporatefinance.mckinsey.com