Bear Markets

In this post, I am not going to be talking about recent economic news, the current state of politics in the U.S., geo-political tensions or the global economy.  I am going to discuss stock ownership, specifically stock ownership for the long term.

During times like January (and some days in February), people ask me what my job is like when the markets are acting like the Incredible Hulk rollercoaster at Universal Studios in Orlando. (I refused to ride it, but my daughter loved it.)  I jokingly say that my avocation is 90% calm and 10% terror, and now we are experiencing the 10% part. In the stock markets, you really cannot have one without the other.

Let’s talk for a minute about bear markets and corrections.  Corrections are defined as a decline in the markets of at least 10%.  Bear markets are defined as a decline of at least 20%.  Both of these seem rather arbitrary to me.  In his book “Active Value Investing,” author and investor Vitaliy Kastenelson talks about the difference between a bear market and what he refers to as a “range-bound” market.  In his opinion, a true bear market is what the U.S. experienced from October 1929 until July 1932.  Every other time period has either been a bull market or a range-bound market.  The most recent range-bound market has been April 2000 through February 2013, with the S&P 500 returning essentially zero, albeit with two harrowing 50%+ drops during this period.

A recent (1/22/2016) Gallup poll revealed that 18% of U.S. investors have little or no tolerance for a stock market decline of 5-10%.  This percentage increases to 21% for those investors who are retired.  This means that 1 in 5 investors in this group would quickly abandon one of the only asset classes that has the potential, over longer periods of time, to grow and outpace inflation.  While I agree that it is absolutely gut-wrenching to watch the market drop by 8% in a short period of time as it did in January of this year, one of the tenets of investing is to maintain emotional discipline, which is easy to come by in calm periods, but in scarce supply during periods of volatility.  There is an old saying about the stock market: “Stocks take the stairs up, but the elevator down.” Always remember, however, that the elevator buttons say “up and down”, not “soar and plunge.”  Remind yourself of that the next time a pundit on CNBC uses the word plunge to describe a 2% drop in the S&P 500.

JP Morgan puts out a great publication very quarter, their Guide to The Markets, which includes over 60 pages of charts.  One of the compelling ones this past quarter was about annual returns and intra-year declines in the S&P 500.   For instance, did you know that in 1998, at one point the S&P had declined by 19%, only to finish the year up 27%?  That was the Asian currency crisis.  In 2009, during the financial crisis, the S&P 500 lost 28% early in the year, only to finish 23% in the black.  These were absolutely terrifying times, for sure.

I am not advocating being fully invested at all times.  One of the research sources we use has an allocation model, dividing assets between cash, bonds and stocks.  They have a neutral, maximum and minimum allocation to stocks.  However, the model is never 100% in cash or 100% in stocks.   At one point in 2007, their indicators had them cut their stock allocation to the minimum.  Yes, they then missed the 2008 waterfall decline, but in the meantime left some returns on the table.  The one thing that investors dislike almost as much as losses is missing out on current returns. It is a very fine line. That is the investing conundrum. There is always “that guy” at the cocktail party who owns Facebook or Amazon.  What he doesn’t tell you is that he only owns 100 shares or that everything else he owns has been a disaster.

The question is then what to do in range-bound markets.  Let’s take a look.

  • If you are making withdrawals to support your lifestyle, then have two to three years of withdrawals in cash or cash equivalents.  While you will earn very little on this portion of the portfolio, you will not lose money either and you will have liquidity. 
  • Have a bond portfolio that is a bond portfolio.  You don’t want to have equity-like losses in a bond portfolio.  Many people who have been chasing higher yields over the last few years have experienced this. A perfect example of this is high yield bonds of energy companies.
  • Take profits now and then from the stock portion of the portfolio.  Use excess cash to buy when opportunities arise.  If you are using actively managed mutual funds, some of this may be happening for you within the funds.  If you are using index tracking exchange-trade funds, it is not as you are always fully invested.
  • Pay attention to the psychology of the market.  If everyone appears to be in a buying frenzy and thinks the market will never go down, reduce exposure. Remember when cab drivers were giving stock advice in 2000, or real estate advice in 2005? If everyone is scared and selling, you might look at adding some equity exposure.
  • Stay diversified.  Most of the time, diversification works.  In 2008, as everyone was rushing for the exits at once, it did not, but that was an extraordinary period.

Finally, while the volatility of late has been disconcerting, Morgan Housel of The Motley Fool did some research on the historical volatility of the U.S. stock market, going back to the 1920’s.  While he discovered that the volatility of daily market returns from 2010 through 2015 was higher than in most decades, the standard deviation of annual returns during that same time period was one of the lowest in history.  The second-highest volatility on an annual basis was the decade of the 2000s, which is not surprising, given the two 50%+ declines in that period.  The point Mr. Housel was trying to make is that a calm stock market has only existed in our memories.  It is similar to how we are nostalgic for “the good old days” when they were not that great after all. The full article can be found by clicking the link here.

I am going to end this commentary with a couple of quotes from Warren Buffett, one on stock market volatility and the other on the benefits of holding cash.

“Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

“We will never become dependent on the kindness of strangers… We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.”

That Buffett character is pretty sharp, I think.