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"The art of living (investing) resembles wrestling more than dancing, for here a man does not know his movement and his measures beforehand. No, he is obliged to stand strong against chance and secure himself as occasion shall offer." -- Marcus Aurelius

Our current market continues to look reasonably healthy to me, but interest rates aren't going to stay low forever. Eventually we will be faced with a bear market once again. Now is the time to have clear in your mind what your strategy will be for handling it. Waiting until it arrives will be too late to mount an adequate defense.

Have A Plan For Raising Cash

If we look at the performance of the S&P 500 in rolling decades from 1930, we find that the worst one was the first one, ending in 1940 with a CAGR of -4.2%/year (nominal). Btw, the best one ended in 1959 with a CAGR of +21.4%/year. The second-worst rolling decade was 1972-82 due to the severe inflation back then and the DJIA vacillating back and forth across 1,000.

We can't accurately anticipate when another bear market might hit or how bad it could be. But recessions are not rare, so we need to have a plan for raising and redeploying cash if the market starts to roll over, as it could be doing now. Without a contingency plan for a weak market cycle, our decisions will be based more on emotion (and regret) than on logic. As many investors eventually realize, our market decisions are a greater risk to our portfolios than the market's actual performance.

Let's start with a few common sense steps. You start taking these steps when your green light about the market's direction changes to flashing yellow. For some, this might have happened recently when the DJIA broke through its chart support, ending a reasonably lengthy uptrend (at least for now). Your "rolling over" signal might be something else, but whatever it is, you need to have some combination of factors that net out to cause you enough concern to justify starting to take the following steps.

A) Start raising cash and repositioning assets.

Sell stocks, ETFs and mutual funds, or part of them, where you are less confident about their prospects in the next bull cycle. This generally means selling assets you don't regard as core holdings. A bear market will often cause greater drops in price in these non-core holdings. If you notice your core positions are down by -10% but your non-core holdings are off by -15%, this tells you what the market is more interested in going forward and what you should start underweighting or liquidating. This is a simplistic form of sell discipline.

The market will eventually settle primarily on quality, so that's where you should eventually do your buying. Either buy more of your core positions when you see the market headed back up or at least has ceased its decline, or/and buy new quality positions on your targeted list. When the market is correcting, stay out of "flyers."

B) Reexamine your goals and risk tolerance.

If your goals and risk tolerance have changed for some reason, fine, but remember that goals are not defined by a "required" market return. The market's long-term return has been about 10%/year. If your risk tolerance reads "aggressive" and you want all of your portfolio in the market, then it would make sense to have a target CAGR of 10%/year. But if you know your risk tolerance is "moderate" and you conclude from this that your asset allocation should be two-thirds stocks and one-third bonds, then your targeted CAGR goal would be about two-thirds of that 10%/year and one-third of the CAGR for some bond index.

The mistake to avoid is when people haven't done the arithmetic described above and then decide they want a higher return (don't we all), so they put more money into the market, a higher risk asset than their risk tolerance would dictate. This would be an asset allocation based on hope, not logic. Many a sad result has started with an unrealistically high CAGR goal followed by increasing one's risk tolerance in an ill-advised effort to accomplish it. Stick to the asset allocation indicated by your risk tolerance. (There are questionnaires that do a reasonably good job of helping you determine your risk tolerance. They are multiple choice, no wrong answers, a simple piece of homework. If you'd like one, let me know).

C) If you're not sure what to do, stay invested.

The worst thing you can do is sell out after a bear market already has you by a leg. If you failed to raise cash when a downturn started, don't suddenly convince yourself that the sell-off looks too threatening to your financial health, so "better late than never" as regards selling. It's probably better by then to just hold on, white knuckles and all. By the time you think the market might wipe you out, it will likely be near a bottom. People who failed to raise cash relatively early in a significant correction ("significant correction": one that makes you wish you'd seen it coming) are those who had no plan and no sell discipline.

If you've raised cash, don't wait around too long before reinvesting it. "Too long" would probably be about a year, as the average recessionary correction has lasted about a year and a half. Just remember that the market will bottom out before economists say the recession is over. But having the patience to hold cash for a while in our current environment is OK, too: low interest rates prevent you from making much on it, but low inflation wouldn't be eating it up very fast either.

D) Buy while you're still nervous.

If you've raised cash and see the market starting to establish some support again, start buying your targeted quality assets. It's OK, even a good idea, to wait until the market breaks up through downside resistance, then stages a "retest" (a minor sell-off). If the low on this retest is higher than the market's low when it bounced back up through resistance, that's a good buy signal. No guarantees, but the odds will be with buyers in that scenario. The point is, don't wait to buy until you feel OK about the market again. Buying right after or near a bottom will probably make you nervous. That's what buying low feels like most of the time.

If your portfolio is "only" down -40% (not unusual in 2001-2 and 2008-9) and if its performance returns to a more historical average market return of +10%/year and does this for 16 years, then it would manage to stagger back to a CAGR of +6.5%/year over those 16 years. That's like having stock market money making bond market returns. You have all the risk but not the returns. The morale is that large portfolio losses destroy or severely compromise prospects for good future growth. Don't ignore that risk.

Recoveries from bear markets

Historical records clearly show that bear markets haven't had much longevity, despite the sometimes severe damage they've done. But what assurance do we have, if any, that once a bear market is over, the market will recover impressively? OK, let's look at some bear market damages and what the market's performance was one year later:

Start of Bear Market

May 1946

Length of Bear Market (Months)

11.8

Maximum Decline

-23.2%

1 Year After Decline

+14.8%

April 195618.8-19.4%+22.6%
Dec. 19616.5-27.1%+24.4%

Feb. 1966

8.0-25.2%+20.2%
Dec. 196817.9-35.9%+30.1%
Jan. 197323.1-45.1%+29.7%
Sept. 197617.5-26.9%+7.9%
April 198115.7-24.1%+34.3%
Aug. 19871.8-36.1%+18.6%
July 19902.9-21.2%+20.7%
May 200117.2-35.7%+28.5%
Oct. 200717.0-53.0%+61.1%

You can see from this table that since WWII, as a general rule, the damage from most bear markets has been mostly "repaired" by a year after the maximum decline. September 1976 was a dramatic exception to this. But the important thing is the overall pattern. (We can't compare the two columns of percentages directly because they have different denominators, i.e. market values. But a year after these maximum declines the market had erased an average of about 3/4 of a given decline.)

What's your smartest choice after the damage has been done?

Next, let's look at what would have happened to your market portfolio during and after the 1973-4 bear market, at that time the worst one since the Great Depression, now known to have caused a market drop somewhat less than the one in 2008-9. Suppose you'd invested $10,000 in the S&P 500 index on January 11, 1973. If you had held on, you'd have seen your original investment degrade to $5,520 on October 3, 1974, for a whopping loss of -45%. OK, that's the bad news. But you'd have had choices. Let's look at five of them, identified by five hypothetical investors:

  1. George held on to his S&P 500 position, deciding to stick it out.
  2. Hank sold out, then waited a year before reinvesting in the S&P 500 again. He decided to take a breather until the market looked OK.
  3. Paula added another $10,000 to her S&P 500 position. She saw a big loss as implying a buying opportunity, trusting that the market would improve.
  4. Jack decided to add $1,000/year to his position in the S&P 500 for the next 10 years. He couldn't afford to add a lump sum as Paula did, but he felt, long term, the market would probably turn up.
  5. Lara sold out and went into CDs. She kept rolling over her CDs, making compound interest. She'd had it and decided to pull out while she still had money left.

Using the market bottom date of 1974, here are the long-term results about 30 years later, looking at what each investor would have accumulated:

  1. George held on. $228,955
  2. Hank waited a year, then reinvested. $158,517
  3. Paula added another $10,000. $643,703
  4. Jack added $1,000/yr for 10 years. $458,462
  5. Lara sold out, went into CDs. $ 38,939

We just looked at one dramatically bad bear market, but you can see the general lesson: at the very least, hold on, but better yet, buy more.

(The above figures neglect transaction costs and assume dividends were reinvested. CD results were six-month average CD rates as reported by the Federal Reserve Board, according to AIM Distributors, Inc. as of August 2002.)

How do you know when the bear is about to hibernate again?

Well, you never know for sure. I've already described one chart sign, the "dead cat bounce and successful retest" chart signal. But there are lots of signs that at least give you the impression that you're probably at a pretty good buying point, if you have the dry powder. Here are a few, followed by a comment relating to 2013:

a) You'll see a story, chart or graph showing that recently there was a big spike or growing total in the money going into bond funds. [We've already seen this. Money might be coming out of longer duration bond funds now, net, with rates creeping up.]

b) Stories emerge about increasing numbers of bankruptcies. [Quite the contrary, we've seen stories about the overall strong health of corporate America.]

c) Unemployment looks bad, typically greater than 6-7%. [This is an old story now. It's been gradually improving over the past year or so.]

d) Stories about cuts in corporate spending--CAPEX as one example; companies dropping various plans for expansion, acquisitions, selling assets to pay down debt; maybe restructuring stories; IPOs being cancelled. [Again, we've recently seen much the opposite. Companies are cash rich now, with stock buybacks, dividends being instituted, acquisitions continuing.]

e) Stories about traders who have made big profits from short positions. [But not in this market. Gold shorts have cleaned up.]

f) You might see estimates of large amounts of "sideline" cash. [With interest rates so low now for so long, we've seen just the opposite again: more money coming into dividend stocks, some from long duration bonds now that those prices are starting to suffer as rates creep up.]

g) Articles about older employees having to put off retirement; investors suing broker-dealers for losses.

The Chinese got it right

There is a lot of wisdom about how to handle bear markets in the Chinese symbols for "crisis." Taken individually, one means "risk" and the other means "opportunity" (I don't know which is which). There is a powerful lesson there.

Bear markets do have risk, of course, as stocks always do. But they also provide opportunity in the low prices they produce. The one thing that most influences the future long-term performance you'll see out of a stock, more than any other one factor, is the price you pay for it. It takes guts to buy when a bear is on your porch, but that's when it's giving you the best prices. And they've all wandered off again.

A bear market is all about faith. Faith in the opportunities our U.S. Constitution offers and faith in our fellow American citizens who will figure out how to take advantage of those opportunities, creating new companies and hiring new employees. We Americans have shown many times that, despite our bungling sometimes, we know how to solve economic and business problems and how to continue to exercise innovation and creativity.

So the next time a bear is growling on your portfolio's porch, just think to yourself, come on America, we can do better than this. If you hang in there with your investment plan and let others act on their fear and emotions then your faith in this country and its markets will be rewarded.

Sometimes you'll need a stout heart and some serious courage, but that's exactly what our forefathers had who risked everything to create this country and to give us the market system we've used so productively for so long. A bear market tempts us to lose faith in this system. We even have some currently who decry it. And the day will come when we'll be tested again.

But even if you think I'm being a bit maudlin here, I'm sure you'll grant one present day fundamental truth, bear markets notwithstanding. That truth is that nearly the entire world now functions with some form of free market capitalism or various versions of it. If somebody thinks this economic system doesn't deserve our faith, let him or her explain to six billion people why they're wrong.

Source: Do You Know How To Handle A Bear Market? My Answer: With Faith

Additional disclosure: This article is intended to be of an educational and general advisory nature. Any investor should evaluate advice in terms of his or her own personal financial situation.