Today, we are in a strong bull market that has been so resilient that we barely have seen any sizable corrections. It is a certainty, however, that we will have another bear market. A bear market is a prolonged period of time where market prices fall significantly. No one knows exactly when that will happen next, how deep it will be, or how long it will last. Since the 2000 peak, we have had two major bear markets.
There are a number of approaches that an investor can use to confront the next bear market. I believe it is important for investors to formulate a plan ahead of time, so that their actions will not be dictated by their emotions.
Some Basic Concepts
The chart below shows one of the boom and bust cycles of the S&P index. The market peaked in 2007 and started its decline. The decline accelerated in 2008, and bottomed in the spring of 2009. When the market is approaching a top, as it did in 2007, the upside in prices is limited, while the downside is large. The red line on the graph is a 30-week simple moving average. Notice that when the slope of this average turned negative in late 2007, the bear market had just started. The next best chance to get out of long positions occurred when the S&P index re-tested this moving average from below, but did not significantly move above it.
(chart courtesy of Google)
The moving average turned up in 2009, after the market had bottomed. Before the moving average turned up, the S&P index crossed above the moving average and proceeded to stay above it for most of the year. The slope of this moving average stayed positive until mid-2011. The negative slope in mid-2011 could have been the start of another bear market; however, this was a false signal that became apparent a few months later. The price moved below the moving average for about a half year, but crossed above it again in early 2012.
Confronting the Next Bear Market
Some potential approaches to deal with the next bear market include:
1. Stay fully invested and it ride out. Because bear markets have tended to be a lot shorter than bull markets and because the general trend of the market has been up, this may not a bad approach. To succeed with this approach, you need to have the mental discipline to ride out the draw down in your account and have the time for the market to recover. People that used this approach for the last bear market have seen the market surpass the 2007 peak, 6 years later. The major advantage of this strategy is that you do not have to decide when to re-enter the market.
2. Stay fully invested and utilize trailing stop losses. Trailing stops move up as each equity position moves up. Trailing stops are one way that you can let your winners run and help protect yourself against the next bear market. With this strategy, you need to have the discipline to allow the stops to work and you have to have reasonable stop losses percentages to over ride normal market noise. Once you have been stopped out, you must also have the courage to get your funds back into the market at some point. There are still a lot of people that did not have the courage to deploy their cash since the market bottomed in the spring of 2009. Unfortunately, many people only get the courage to re-enter the market at market tops.
3. Lighten up on your exposure by selling your most vulnerable positions and raising some cash. This allows you to mitigate the loss, if another bear market occurs. It also helps to limit your regret if the bull market keeps raging on. You might want to take profits on momentum stocks that have been driven up to ridiculous valuations because they may have the furthest to fall. Your cash will be more valuable once the bear market ends, because you may be able to buy great companies at bargain prices. The possibility of picking up great companies at bargain prices is why cash is considered to be a perpetual call option. This call option has no value unless you also have the courage to deploy this cash when the market is hated by almost everyone.
4. Buy puts or inverse ETFs. Puts on the market and inverse market ETFs will go up in value, if the market declines. The inverse ETFs cut both ways, and if the market goes up, the inverse ETFs will decline. Puts, on the other hand, limit your loss to the premium you pay (plus commissions), but have an expiration date to deal with. With a put, you must decide on the appropriate strike price and time to expiration, and the market will tell you what premium you have to pay. One of the problems with buying puts is that they may expire worthless if you are wrong about the direction or timing of the anticipated market decline.
5. Rotate your holdings to more defensive sectors. Some sectors go down a lot less than the market for a market downturn. Historically, utilities and consumer staples have been the example of this. The drawback with this strategy is that defensive sectors may only be a temporary hiding place and will eventually follow the market down and enter their own bear market.
6. Only hold dividend champions. Companies that can pay and increase their dividends for 25 or more years are probably great businesses. If they kept paying and increasing dividends through tough times in the past, they are likely to keep paying if tough times return. These dividend champion companies will in all probability survive any downturn we may encounter. So even though their price may decline, they keep paying a dividend while you wait for them to re-bound.
7. Buy US treasuries. In the past, steep market downturns have inspired investors to flee to a safe haven. Cash and US treasuries fulfilled this need. If you look at Fidelity Government Security Fund, you will see it actually increased in value in the last bear market. No one knows for sure if US Treasuries will continue as a safe haven going forward, but my guess is that they will.
This article has pointed out several approaches which may be helpful to plan for the next bear market. I am sure there are many more. All of the approaches discussed above have advantages and drawbacks. One size does not fit all. Coming up with a suitable plan is very dependent upon your particular situation and how you react to that situation. Willing or unwilling, we each make a choice when we are confronted with change. It is my opinion that having a well thought out plan before we enter the next bear market will help minimize a knee jerk emotional reaction that could be very destructive to your wealth.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.