I have been hearing enough chatter out there about the possibility of a bear market to feel compelled to comment on such nonsense. First of all, bear markets do not occur when everyone is worrying about them. The large number of warning articles I have seen lately, if anything, is probably a signal to buy, not sell stocks.
Second, most of the doom and gloom commentary comes from financial theorists, not practitioners. Why anyone would take serious investment advice from journalists, economists, or academics continues to baffle me. Assuredly, many of these professionals are highly intelligent, possess keen insights, wield superior analytical skills, have won numerous awards, and may have countless professional successes. However, none of these accomplishments necessarily qualify them to help us make money in the capital markets.
Third, any serious investor knows the tell-tale signs of a bear market, and would have to admit that almost none of the typical harbingers exist right now. So let’s review what history can tell us about bear markets.
1) They almost always begin six months before the beginning of a recession. If someone can produce a credible analysis suggesting a recession by the end of 2014, I’d love to see it. No credible economist is predicting recession in the foreseeable future. There have been 14 recessions since 1929 and bear markets occurred in every one of them. I am not sure how many recessions have been forecasted over this period, but I’m sure it’s much higher than 14…
2) They occur after a period of considerable tight money policy by the Federal Reserve. The current forecasts suggest that the Fed may begin raising the Fed Funds rate (the first step to tighter monetary policy) sometime in 2015. There is a big difference between less easy money and tight money. When we actually see tight (and not just “tighter”) monetary policy from the Fed is when we should begin to worry about the bear.
3) Bull markets end (and thus bear markets begin) when the mood of investors is “euphoric.” Some commentators are trying to paint the current mood as overly enthusiastic (obviously this is a judgment call – there are no infallible metrics for this), but I’m not feeling it. The large amount of Initial Public Offerings is a yellow flag, as is the large amount of cash flows into equities and equity mutual funds. Yet, many of the sentiment measures are mixed – not suggesting any widespread euphoria.
4) Bear markets often occur after a binge of borrowing. Increasing usage of debt can often fuel the final stages of an economic recovery. People who are feeling confident about the future will borrow money to invest, expand their business or simply buy stuff. This can lead to stretched balance sheets that reduce financial flexibility and can produce cautiousness that often causes, and then exacerbates, an economic slowdown. Debt levels at the corporate level are far below those seen at normal economic peaks. Household debt has started to rise again, but remains well below cyclical highs.
5) Bear markets often begin when corporate profits and margins begin to fall. It seems that nearly every quarter since 2010, some strategist was out there predicting the end of the current earnings growth cycle. So far, all of these forecasts have been wrong. Consensus estimates suggest another record year for corporate profits in 2014.
There may be other factors coincident with bear markets, but I think the items above are sufficient to conclude that a near-term bear market is next to impossible.
So back to the question at hand – what to do in a bear market? For someone possessing perfect foresight the answer is easy – sell all stocks and reinvest when the market bottoms. For the rest of us, the formula is more problematic. Selling stocks in times of worry feels very intuitive and doubtless provides the seller with some comfort. More often than not though, it is exactly the wrong thing to do. But, let’s suppose one does raise cash in front of a bear market, what then? Holding cash as the market declines may feel good (offset by the sinking feeling caused by the shrinking paper value of one’s portfolio), but will that same seller have the fortitude to buy back the positions sold near the bottom of the market? Human nature suggests that this is very unlikely. We still hear about people who sold in 2008 or early 2009 who are still holding cash. They were paralyzed by the market’s decline and could not bring themselves to re-invest. The saddest part of this development is that the market has recovered all that was lost in the 2008-2009 bear market and more.
Ironically, the person who made no changes to their asset allocation during the last bear market likely did much better than anyone who tried to trade in response to it.
Do you recall anyone who told you to sell stocks in October 2007 and then buy them back in March 2009? Me neither…
So what do I do in a bear market? Usually, I stay fully invested and do not make changes in my asset allocation. In the late 1990s, I had actually raised some cash in my portfolio (only time ever) because I thought the euphoria about tech and telecom stocks was way over the top. I was fully invested in October 2007 and by late 2008 thought that the bear market was over! As wrong as this opinion was, I did not waver in my resolve to remain fully invested through the bear market and I did. Although it was more severe than most people expected, it lasted just about as long as the average bear market. I was greatly rewarded for my discipline and resolve, and my portfolio is much larger than it was in late 2007. I know a lot of people whose portfolios have likewise prospered by remaining true to their asset allocation and investment discipline.
It’s important to note that most investors with longish investment horizons (five years plus) should be able to easily endure the average bear market. The last bear market was highly unusual and even more unusual was the flat stock market period from 2000 to 2010. One must remember that this “lost decade” began with the biggest stock market bubble of this generation. The last time stocks flat-lined for ten years was in the 1929-1939 period. That seems about right to me. We can expect a massive bear market like we saw in 2008-2009 about every 80 years or so.
To sum up, I see no bear market on the horizon. Most investors can endure a typical bear market without any dramatic portfolio changes. Excessive happiness may be the best predictor of a bear market.