David Brown's view
A bear market will come. We cannot know when with any certainty, but we can be certain it will happen. We really do need to think through in advance how we will respond. Can we private investors structure our portfolios and design our methods of investment so we don’t have to panic when that bear bites?
This article outlines my thinking and the kinds of action I have taken with my own portfolios in past bear markets. These ideas may not be right for you, and they are certainly not perfect as we learn from each new bear market we experience. The important thing is to think it through yourself and make plans you will adhere to and avoid poor decisions when under emotional pressure as markets fall.
Can we predict when a bear market will happen?
No method is perfect. I have tested indicators carefully over many years, but even so I cannot have absolute certainty that the various measures I use will help me raise cash before the next bear market. - Looking back over many decades, the yield curve would have been predictive most of the time but not every time. That is why I also use two other methods, the Conference Board Leading Economic Index (LEI) and the ‘Sell in May’ strategy. - The LEI indicator has data for several decades past. Its predictive power looks impressive for those years but we cannot know how it would have performed further back in time, or how it will perform in the future. - Sell in May provides a further level of protection as bear markets can be particularly vicious during those seasonally weak months of the summer. Use of this method means I will have smaller gains during summer months in the strong years of a bull market, but my back-testing indicates this is much less important long term than the positive effect of avoiding big market falls. Sell in May forces me to raise cash once each year (typically 30-50%) so I am well-placed if it is clear by late summer that a bear market has started. In bull markets, I usually aim to redeploy that cash back into the markets during from mid-October and during November, but if markets stay weak I would delay doing so. - Use of a long-term moving average crossover such as the 6month/12month crossover provides a tool to warn of the latest time I should be positioned for a bear market if the other indicators above are flashing warnings.
Why do I not stay fully invested in a bear market?
My methods are very different from those of financial advisors and brokers, who tell their customers to stay fully invested and to not to try to time the market. Individual investors might agree they are ‘long term investors’ who will take the dividends and watch their capital be eroded during that typical 30-50% fall. Actually, some bear markets have seen falls much greater, over 70%. It’s fine in theory for financial advisors to say ‘stay invested’ but think about it. How would you handle that emotionally? Would you really hang in there? Even if you do, would it be wise? Let’s keep the maths simple. A 50% fall (halving) in value of your portfolio means you will need a doubling (100% gain) just to get back to even. So, you spend two or more years of anguish watching your investments halve in value, then several more years waiting just to get back to even. If that happens most decades – and there is a bear market most decades - I cannot see how an investor can build wealth. It only makes sense to stay fully invested in shares if your sole interest is the dividends and you are not concerned about capital gain – if you can stomach those big swings in value of your capital.
Worse still, my guess is that most people fail to double their money in a bull market anyway so the overall effect of sitting out a bear market could be to destroy capital wealth. The following is likely the experience of a typical investor. Initially they do not recognise that a bear market has started. Then they decide to sit it out when 20% down. Panic sets in as the losses increase further – “all my retirement money is going” – and they finally sell near the market bottom. With a large loss crystallised they are highly unlikely to repurchase when the new bull market starts so they lock in a permanent loss and never want to go near the market again.
Would you do that? Have you done that! Be really honest with yourself. If you have been through bear markets several times, as I have, then you have a much better chance of knowing what your emotional reaction will be. For me, I have repeatedly experienced getting really unhappy if my account falls by more than 10%. Therefore, I have developed methods that (hopefully!) will prevent that ever happening again, though I cannot be certain. We each need to experience, acknowledge and act on our own discomfort level. Our plan must take our emotional reactions into account. It is arguably the most important consideration.
Here are some of our options during a bear market.
1. We could go 100% cash, then aim to fully reinvest near the market bottom. Ha ha, only joking. Anyone who succeeds in doing that was just lucky and is unlikely to succeed a second time round. Picking market tops is notoriously hard: knowing when a bottom has formed is even harder and there is very little published research. (Now, there’s a PhD thesis for some enthusiastic student).
2. If one really needed dividends all year round, then the classic 60:40 equities: bonds allocation would provide these dividends if it was used without the seasonal buy and sell rule. My back-testing indicates that capital falls could be 20% or more but still less than the overall market, with dividends compensating for some of the fall in capital. This is not one I use, due to the capital fall potentially being larger than I tolerate, but for those with stronger stomachs it is a reasonable choice. Alternatively, to reduce volatility, maybe 20%-40% of a portfolio could be held in cash and the remainder allocated to a share index fund and government bond index fund in that 60:40 ratio. Or one could reverse the ratio for the duration of the bear market. There are several possible combinations here.
3. Some things do go up as stock markets fall. It is possible to make money from a falling market by shorting the indices or shorting individual shares. In the past, I have used both short ETFs and spread-bets (‘options’ are the equivalent for those not based in the UK) to capitalise on falling markets. This acts as an additional hedge to protect capital in a portfolio if some other long positions in shares are retained. Use of short ETFs for capital gain is a tough game though because bear markets are punctuated by rapid upswings, when the short positions will generate losses. Bear market downtrends tend to be more rapid and their directional changes and magnitudes larger than price movements during bull market uptrends. Also, when short, one owes the dividend payments to those to whom you effectively sold the shares, an additional factor to consider. Skill in trend following, use of relatively small position sizes, and adherence to strict stop losses are all essential if one is going to short the market for capital gain.
Those are some possible responses to a bear market. Do you have other ideas? It would be great to share.
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