The Bear Market is Coming (if it’s not here already)

“Rule No. 1: Don’t lose money.  Rule No. 2: Don’t forget Rule No. 1”

– Warren Buffett  |

The S&P 500 lost 57% of its value during the 2008-09 Financial Crisis. And it took over 3 years to recover.

It lost almost that much during the Dot-com Crash (the Nasdaq lost over 70%).  And that time, it took over 4 years before the S&P came back. 

In fact, from August of 2000 to December of 2010 the S&P only spent a total of 18 months above its pre-crash high.  That’s only 18 months in profitable territory in over 10 years:

And from where we’re sitting now, this could easily happen again.

Sure, the years since have been fantastic, and the market has had some impressive gains. But that’s just it. The market is now at stratospheric levels. The Price/Earnings, CAPE and Price/Sales ratios are all near or at all-time highs. And those numbers are likely understated due to the large amount of private equity investments that are not factored into the public market valuations.

The market and the economy are also structurally weaker than they’ve been in several decades. Here are a few numbers from the run-up to the 1999 peak and Q2 2018. As you can see, every metric listed is worse now than it was back then. Government debt and deficit, as well as corporate and personal debt are all higher; and GDP, productivity and earnings growth are all lower.  Things did improve somewhat in Q3 (and I’m very much positive on the U.S. economy long-term), but still, currently not a great recipe for continuing an aging bull market.

What makes this much worse is the current course of the world’s central banks – they are all either tightening or are ending their easy money policies. For instance, the Fed’s increasing rates will increase the cost of all that debt for everyone, from housing, credit cards and student loans to junk bonds, corporate debt, margin rates and the Federal Government’s $21 trillion in debt as well.

Specifically, years of easy money policies (read: low interest rates) have lead to a worsening situation in corporate debt.  There has been a spike in the number of firms in the S&P 500 whose credit ratings are BBB – just above junk rating.  And even worse for the future in an increasing interest rate environment, are the rise of zombie firms.  That is, firms that can’t actually cover even the interest on their debt with the profits they earn.  These currently includes such well known names as Tesla and Netflix.

And what happens when interest rates rise further (through central bank’s raising rates and/or investors demanding a higher yield for their investment)?  The weakest of these indebted firms will get into trouble first – missed debt payments, write-downs, restructurings, bankruptcies.  Then the problem risks becoming a contagion, and we have a 2008 all over again.  But this time it could be far worse – due to the massive increase in debt at almost every level of the economy.

No wonder rising rates have begun to spook the markets!

Add to all that, the numerous current geopolitical risks: escalating trade wars, North Korea, Iran, China, political conflict in the U.S. and Europe, multiple possible sovereign debt crises, as well as the lingering effects of Brexit on the UK and EU.

We have high geopolitical uncertainty right at the top of an aging bull market, with massive debt, anemic real growth, monetary tightening and increasing rates (and this is just the 10,000-ft view).  

The point is this: We are back at the precipice. And most investors are not even remotely prepared.

 

Defense (and Offense) Wins Championships

The hottest trend in investing in the last several years has been “indexing”, aka: buy and hold (which has actually become just another form of chasing returns – and this will become apparent when many of the claimed devotees bail out in the next bear market). While indexing isn’t the worst investment plan in the world, it’s not the best plan either (unless you’re fine with average returns, have plenty of time to allow for the compounding of those average returns, and you can hang in there even when you’re down 50% or more).

But there’s no reason to ride out every bear market just because. It’s incredibly stressful and, as history has shown, most investors can’t hang in there. Instead they get out when they “can’t stand it anymore”, which is often right at the bottom.

So what do you do?  You have to prepare for it.

Your investment approach must account for the truth that there are going to be large drops in every asset class, and that “diversification” alone is not enough (correlation goes to 1 at the worst times, like it did in 2008).  Yes, the market could continue up more from here, and you want to be sure and take advantage of profitable periods, but you also need a plan to miss those massive drops.

The importance of avoiding large losses is difficult to overstate: the S&P 500’s average bear market loss over the past 40+ years was -37%.  That means it would take a gain of well over 50% just to get to break-even.  Assuming the S&P’s long-term average growth rate over the past 40+ years of just over 10%, getting back in the black would take over 4 years.

The common advice is to diversify, have a long-term mindset and dollar cost average (invest the same about every month).

First of all, when most advisors (human and robo) talk about diversifying, what they recommend is usually woefully inadequate.  I’ve talked with many financial advisors and taken a look at several of the top robo-advisor portfolios.  They are still often 60%+ in domestic stocks.  The rest is international stocks and various bond indexes.  This is little more than lip service to true diversification (to say nothing of paying fees on each of the underlying funds in their portfolios in addition to what they are charging for their services).

As for investing for the long term, if we’re talking about a bear market on the order of 2000 or 2008 – a loss of more than 50% – then you would need to more than double your money just to get back to break-even.  The peak before the financial crisis was in 2007, and the market didn’t recover until March of 2012.  Are you fine with essentially zero return for 5 years?  Can you hang in there that long?

If you’re still planning on indexing or investing in a commonly recommended portfolio, then dollar cost averaging is the way to go.  Your monthly investment buys you more when prices are down and less when they are high.  Also, the imposed discipline of monthly investing keeps most people contributing and in the game.  Both good ideas.

 

We Need to Talk (what to ask your advisor)

To be sure you’re prepared, you should have a conversation with your advisor (human or robo), and ask for some detailed info about your portfolio.  If you manage your own investments, be sure you answer these questions for yourself. 

When assessing your advisor’s advice, consider this: the are many advisors and money managers with almost a decade of experience, many in very senior positions at this point, who have never seen a bear market (since the last one was ten years ago).  Also, many advisors have a very limited playbook – they may be offering only the “traditional” advice because that’s what they learned and that’s all they know, and many can only offer you products from their parent company’s preferred list.  

Regardless, you need to be sure you’re ready for whatever comes.  Here’s what to ask:

  1. What are you invested in? – This seems obvious, but often it’s not.  I’m still amazed at how often people tell me, “Yeah, I have an advisor that I work with.”  “What do they have you in?”  “Oh, I’m not sure.”  Wait, what?  I mean, I get it.  If you have an advisor, then you expect them to be professional, know what they’re doing and be looking out for your best interest.  But, at the very least, you should still know what you’re invested in and why.
  2. What is their plan for a bear market, if any? – Ask them, “What is your plan for my investments if we have another 2000 or 2008-like bear market?”  Will they diversify?  Hedge the portfolio?  Sell some and go into cash?  And how will they know when to implement that defensive stance?  They may tell you not to worry – that the economy and markets are strong now.  Tell them that sounds great and you hope they’re right, but you’d still like to know what the plan is if and when the market starts to turn.  (First off, they don’t know for certain – the “experts” have historically been optimistic at exactly the wrong time.  And secondly, you need to have a plan because another bear market is like a large asteroid hitting the earth – the likelihood of it happening on any given day is small, but the probability of it happening again in the future is 100%.).
  3. How would your current portfolio (from Step 1) and their plan for a bear market (from Step 2) have performed in previous bear markets? – Your advisor will probably not like, or might outright balk, at this request.  Yes, market and economic conditions are always changing and aren’t exactly the same as they were in the past, but it’s important to get at least an idea of how you might do in bear market conditions.  As Mark Twain is often (questionably) credited having said, “history doesn’t repeat itself, but it rhymes.”  If this is a non-starter for your advisor (or your robo-advisor doesn’t offer this level of personalized service), you can do it yourself pretty easily.  Just get the monthly historical prices for your holdings (Yahoo! finance has historical prices on many securities), properly weighted the same as your investments, and see how your portfolio would have performed in the two most recent bear markets: 2000 to 2003 and mid-2007 to mid-2009.  This will give you a general idea of how you can expect things to perform in the next bear market.
  4. If you don’t like what you find, look for a better plan. – When it comes down to it, your investments are ultimately your responsibility.  Do whatever it takes to be sure you’re prepared and comfortable with your investments and the advice your paying for.  Ask your advisor what else you can do to prepare for a downturn.  Look for a different advisor.  Educate yourself.  Find a plan that can help preserve your investments, but still enables you to profit if markets continue to rise.  If you want a simple, effective approach for investing in all environments that you can implement without the help of an advisor, we’ve outlined a straightforward approach here.

Hopefully, going through this process will give you confidence in your current portfolio and an understanding of its possible performance in a down market; or you’ll find where your plan is lacking (or that you didn’t have one at all).  And, if you still plan to buy and hold no matter what, then begin to prepare yourself to ride out several down years – in the long term (on the order of a decade or more) you’ll be fine as long as you hold fast.


However, it is far better to truly diversify, to systematically exit falling markets, and re-enter as they improve.  Our investment approach does just that:

  • We assess 61 assets classes and sub-classes all over the world for the best opportunities.
  • Our defensive algorithms monitor every position to protect profits and avoid losses – we are sometimes 100% in cash when conditions warrant.
  • Our quantitative futures component can make money in up or down markets.

If you’re interested in the possibility of avoiding the worst of a coming bear market and even the possibility of profiting during challenging times, we’d love discuss our investing approach and see if it’s a fit. 

Please leave a comment, question, or get in touch.  We’re here to help.

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sleep soundly during the coming bear market
and still take advantage of profitable opportunities.

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