You Can Afford To Protect Against Bear Markets

 |  Includes: DIA, QQQ, SPY
by: Brian Ingham


Since 1996 the markets of USA and Canada have been volatile rising three times over 100% and falling twice over 50%. Some pundits forecast more of these big swings ahead.

These pullbacks are nerve racking for an investor who stays invested and potentially costly for them if they mistime their exit and reentry while attempting to avoid the pain.

Looking back over 142 years of economic and S&P data there appears to be some simple rules that work well for identifying the beginnings and ends of financial bear markets.

Investing by these rules would have reduced average draw-downs by 60% while improving long term performance (20 years) by 70% compared to buy-and-hold.

Perhaps the most important question for investors is the size and duration of the next substantial market correction. No investor wants to make their purchase just before a major market correction and every investor has had to decide whether or not to ride out an apparent pullback or take evasive action. These pullbacks are nerve racking for an investor who stays invested and potentially costly for them if they mistime their exit and reentry while attempting to avoid the pain.

Let's look at the S&P over the last 140 years. In the chart below, we compare the S&P's performance (black squiggly line rising to the right) relative to a bond ladder constructed of 10 year T-bills. Most of the time the S&P (with dividend reinvesting) outperforms a T-bill portfolio (with interest reinvesting). However, there are 13 extended periods where the S&P underperformed a T-bill ladder giving back all of its prior 5 years of outperformance and more. If you were unlucky enough to have entered the market at the 1929 peak and decided to "ride it out," your portfolio would have devalued by 75% and it would take another 15 years to just get your money back. Being able to endure such a large drawdown and for such an extended period of time is difficult to say the least.

There are now investment products available for hedging a portfolio against this risk such as a VIX index fund, index options or an inverse index fund; should you use them and when? The answer is it depends on how well you can assess the risk of an imminent large pullback as hedging all the time is costly. These falls in the S&P in excess of 25% occur on average less than once per 10 years. So if you had a good read on bear market risk you would only need to rebalance or hedge / unhedge your portfolio less than twice per decade. That is not a lot of work to improve your long-term performance while substantially reducing portfolio volatility along the way.

Click to enlarge

Data sources: Robert Shiller, Yale University database, Board of Governors Federal Reserve, GS1 and H.6 reports

The vertical lines positioned at each market inflection point (bottom or top) show the % rise or fall of an S&P index-based portfolio as measured against its value at the prior inflection point. These are bounded by the black range bands as a means of visually identifying possible trends. The blue squiggly line within the bars is a composite metric of common economic and market direction indicators. The main components of this metric are the Fed's monetary stance, interest rate curves and rate direction, relative yield (earnings vs. interest rates), inflation and wars. The blue dotted-line arrows adjacent to the black S&P value line in the upper section of the chart shows the longer term trend lines for this composite direction metric. The dotted red line shows the actual movement of the S&P index as a % of its own trailing 5 year average. The orange line running through the S&P line shows the market's long term Fair Market Value (FMV) trend line using traditional FMV valuation methods. The squiggly orange line in the middle is the difference between the S&P and its FMV, perhaps an estimate of market sentiment. You can see that the blue dotted-line arrows do project the longer term direction of the market often leading it by a year or more. However, even if the market's longer-term trajectory is somewhat predictable, there is still a lot of meandering around that direction along the way. The market has even risen for many years completely divergent to the direction indicator trend line. But when this happened it eventually whipsawed back, completely eliminating its prior excess rise and often over-correcting, i.e. 1927-1933 and 1996-2009.

So how can you know or at least have a good idea that a bear market has begun or concluded? One intuitive rule that worked for the last 142 years is to exit if market momentum has turned down and either the market has risen more than 80% from its last correction or it is overvalued according to FMV metrics. This is further reinforced if leading economic indicator metrics have peaked and are heading downwards. Also the combination of a falling FMV, falling leading indicators and a falling long-term market momentum correlates well to a larger than average correction… also intuitive. A bear market is usually over when the CBOE volatility index (VIX) is falling from an elevated peak and the market has bottomed at a point nearly as far below its 200 week average as it was above that average at the pre-bear market top. Using these timing rules to protect or rebalance a buy-and-hold investment, you would have bettered your long-term performance by approximately 3-5% per year resulting in a 70% improvement in your portfolio gain on average after 20 years. Over any 20 year period during the last 142 years you would have been far better off to follow this strategy rather than simply buy-and-hold.

The net is that you can do better than a tough-it-out investment stance when financial storms roll through. There are historically reliable tools to measure the risk of a pending bear market and others to gauge when the bull market has arrived. You only need to take appropriate action to protect (or enhance the performance of) your portfolio about twice per decade in order to sleep well and garner a good return most of the time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.