Insights & Advice

|

The Good and Bad News about Bear Markets

Given the number of headlines I have read recently concerning “bear markets”, I thought I might look at both sides of this “tragic” event but first exactly what is a bear market? The official definition is simple: when any index falls 20 % from its peak it officially enters bear market territory. As of yesterday, the S&P 500 index hit 1244– a 20 % decline from its October, 2007 peak. Now, all three of the major U.S. stock indexes have entered that danger zone. We have been there before. Since 1946 we’ve had eleven bear markets and we’ve survived every single one of them.

What few fail to understand is that once we cross that 20 % mark at least 75% of the decline is behind us according to the post-1940 bear markets I’ve studied. That’s not to say you should start buying right now. Most bear markets tend to be with us for at least a year or more and on average we may be facing a total decline of about 26 % on the S&P 500 which could take us down to 1180 or so. Unfortunately, forecasting is still very much an art so we could under or over shoot that number by a wide margin. I’ve seen some predictions that indicate the market could drop to 1,090 which was last hit in August, 2004.

Bear markets rarely drop in a straight line, however. There are usually several sharp, explosive rallies or upward swings (called bear market corrections) which occur along the way. These are great opportunities where investors can raise cash and if you’re nimble actually make money on the upside. And markets can have prolonged moves higher lasting several months at least, so if you’re an optimist (although there is precious few of that breed around right now) you might even see markets move higher at least into the Christmas season.

The second less obvious fact, at least in my experience, is that just about all the homeruns I’ve ever hit in almost 30 years of investing have been made at the end of bear markets. This is when the real values stand out. The game is not to try and call the bottom of the market but to invest in sectors and stocks that offer historical value. Like all bottom fishing, investing in bear markets requires a great deal of patience, due diligence and good old fashion analysis. Your rewards however, can be truly sensational.

One mistake many investors make in deciding what to buy is assuming that the same stocks and sectors that led the markets upward during the last bull market will lead once again. This rarely if ever happens. For example, financials led the market out of the doldrums in 2003. They have also led the markets down this time. Don’t expect financials or homebuilding to lead the charge. My own feeling is that natural resources, things like energy and other commodities will be among the winners coming out of this bear market.

The most important tool investors can use in coping with a bear market is entirely within themselves and has nothing to do with his financial education or her investing experience. The bear’s weapons of choice are first, fear and then despair. Expect investors to succumb to those emotions as we drop lower. There will be bouts of panic among investors combined with the dumping of their best holdings indiscriminately. The winning investor is one with enough cash on hand to wait patiently for those opportunities. In the meantime, you might want to use inverse securities to hedge your investments. Please see my recent column “Inverse Securities—how to protect your Portfolio in Down Markets” for more information on that subject.

It takes foresight and a good bit of courage to stay the course in a bear market but many do and reap the rewards. I hope you will be one of them. If you have any specific questions concerning your portfolio please contact me using the information below.

Posted in A Few Dollars More, Portfolio Advice