Tools You’ll Need for the Next Bear Market

By John Reese (@guruinvestor) — 

Hoping for the best but preparing for the worst is a good rule-of-thumb, a maxim that can help us stay measured and mindful when it comes to dealing with life’s inevitable ups and downs. But it can be hard to think about potential downs when the ups have been around for a while—and the current, nearly nine-year-old bull market is a perfect example of that.

Since March of 2009, the S&P 500, including dividends, is up over 350% as of this writing, and if the current run is sustained until August of this year, it will be the longest bull market in the history of the index. But nothing lasts forever, and the stock market is no exception–which highlights how crucial it is for investors to resist complacency and maintain a realistic perspective.

Here’s some perspective to consider: If you were to look at the day-to-day undulations in equity prices, you would see that stocks are positive just a little over half the time. In a 2016 article, Ben Carlson of Ritholtz Wealth Management wrote, “Stocks don’t make new highs every single day, so most of the time you’re going to be underwater from your portfolio’s high-water mark. This means there are plenty of chances to be in a state of regret when investing in stocks.” He points out that the last 90 years have seen bear markets almost one-quarter of the time. Half the time, he added, “you’re down 5% or worse. It’s difficult to appreciate this fact when looking at a long-term log scale stock chart that seems to only go up and to the right.”

The table below, courtesy of Yardeni Research, shows both corrections and bear markets (the texted in red) going back to 1928.

But knowing that a bear is laying somewhere in the weeds doesn’t help an investor pinpoint when or where it will rear its head. That’s not to say that signs of change cannot be identified–recent research by Morgan Stanley analyzed S&P 500 trends since 1950 to identify patterns that might signal market change in the offing–but such cues are not foolproof.

Signs that Market Change is Coming

Here are a few of the patterns that emerged from the Morgan Stanley study:

  • A widening of credit spreads, the research shows, provides a bearish market signal 3-12 months in advance, with government bonds (on average) peaking about 3 months before the S&P 500.
  • Global equities tend to rise steeply heading into a bear market, with emerging market shares rallying the most dramatically.
  • Rising bond yields, “largely because of the bull market macroeconomic backdrop that spurs growth and inflation.” The research shows that U.S. 10-year Treasury yields have tended to rise by more than 100 basis points in the 12 months before a market peak.
  • A surge in commodities: The Morgan Stanley report says that crude oil, gold and copper have all historically witnessed double-digit increases in the 12 months before a bear market.

Signals, however, don’t offer a crystal ball. There is no sure-fire way to know, or to predict, the coming of a bear market, and trying to guess can end up being a costly exercise. It’s very tough to identify a market “top”, for instance, and most people end up panicking and selling once stocks have already fallen heavily (when they should be buying). Moreover, even those fortunate enough to get out before a bear market hits are often too frightened to get back in to take advantage of a rebound.

Bear Market Tool Box

Instead of trying to predict when a downturn will happen, why not prepare for it? One of the best ways to do so is to establish an investment strategy aligned with your risk tolerance and financial goals—then stick with it.

Here are some things investors can do to prepare for the next downturn.

  • Know your risk tolerance. Think carefully about how much risk you can live with. It’s easy to say you have thick investor skin when the markets are continuing to climb. The reality is, it’s never pleasant to watch your hard-earned savings drop in value. To determine your risk tolerance, it’s important to take into account the stage of your investing life, so to speak. For example, a Millennial might be inherently more risk tolerant than a Baby Boomer by virtue of their longer runway to retirement.
  • Set goals. Map out an investment plan that takes your goals into account, both on a short-term and long-term basis. For example, money you’ll need in the short term (and therefore can’t afford to lose) should be invested more conservatively. Money you won’t be needing in the next five or more years, on the other hand, could be in more volatile assets offering potentially higher returns.
  • Diversify. By investing in the mix of assets that best aligns with goals and risk tolerance, investors can increase their chances of ensuring gains in bull markets and enduring any losses that will occur in bear market periods.
  • Keep emotions out of the investment equation. It’s a mistake to focus on market turbulence, news headlines, and the declarations of market pundits. That will only lead to emotionally-driven trades, which can be costly. Once you’ve established your investment goals and strategy, stick to both. That’s the best defense against inevitable ups and downs.

It’s been a great 9+ years for most U.S. stock investors, and market trends can continue longer than most people think. This bull market could have years left in it – no one knows. But, one thing is certain and that is another bear market will come someday and it will be painful, scary and most likely appear out of nowhere. Investors who understand that bear markets come, and go, and plan in advance and prepare mentally will be the ones who come out ahead in the long run.

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John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Follow John on Twitter @guruinvestor