Winning The Bear Market: 'Teddy' Versus 'Grizzy'

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Includes: GLD, PHYS, SPY, TLT, VXX
by: Eric Parnell, CFA

Summary

A bear market can be defined different ways and mean different things to different people.

Understanding the bear market can mean a big difference between investment success and unwelcome stress.

For those at the ready for the next bear market, great opportunities await.

I recently wrote an article on Seeking Alpha entitled The Next Bear Market Will Be Ruthless. The article sparked a lot of great discussion in the comment section that I enjoyed both responding to and reading a great deal. During these discussion, a topic often came up that was related to the title itself, as some questioned how a bear market might not be "ruthless." Given that so much time in the mainstream media is focused on talking about bull markets, it is often overlooked or misinterpreted what is meant by a bear market. This is because unlike a bull market that is more clearly defined, a bear market can be defined different ways and mean different things to different people. But something as simple as understanding what a bear market represents can mean a big difference between whether you are able to tame the bear and capitalize on it or whether it mauls you into submission. For those at the ready for the next bear market, great opportunities await.

Defining The Bear

The definition of a bull market is fairly straight forward. If the stock market rises by +20% from a previous bear market low, it is considered a bull market. And given that bull markets are characterized by steadily rising stock prices and have traditionally lasted much longer than bear markets over time, less differentiation often exists between how different people define a bull market.

The same cannot be said for a bear market. More often than not, a bear market is defined as a -20% decline in value from a previous bull market peak. But some contend that its not really a true bear market unless it lasts for a more sustained amount of time. Some would state that a bear market has not taken hold unless we have seen a broader reversal in trend to the downside, while others will count individual bull and bear markets that can often take place within a larger and more sustained bull or bear market. And some would claim that a bear market is one that is not just going down but also one that is doing anything other than going sustainably higher. Such differentiations in the definition of a bear market itself can lead to confusion as to exactly what to watch out for when the market has transitioned from one to another. And it is also why so many investors will find themselves trapped in a bear market and not realize it until long after it has gotten underway.

One more final point before going further about the use of the word "ruthless" in the title of my last article. By saying a bear market can be ruthless, it does not mean that the market is going to zero and investors will lose their life savings in the process. Ruthless means cruel or harsh, but it does not mean terminal. And in the case of a bear market, just because it is ruthless in terms of its depth and duration to the downside does not mean that you can't capitalize on it. To this point, gold appears to be finally emerging from what was a ruthless bear market from September 2011 through the end of 2015. But in my conversations with gold investors along the way, while some were frustrated by the steady declines, others were downright giddy at the ongoing prospect of being able to buy gold at discounted prices over the last few years that they thought they would never see again in their lifetimes. So in the case of a bear market in stocks, just because it might be ruthless in terms of its depth and duration to the downside in the coming years does not mean that you can't capitalize on it the same way. For as frequent Seeking Alpha commenter Buyandhold2012 helpfully reminds us, major bear market pullbacks provide us with the opportunity to buy some of the best and highest quality stocks in the world at bargain basement prices. And in the end, who doesn't love a clearance sale?

What Kind Of Bears Are There?

As mentioned above, this is subject to interpretation. But given the following sampling of comments on my recent article shown below, it is important to spend more time with these differentiations.

"any bear market by nature is ruthless."

"And this article's title is silly -- what bear market ISN'T brutal..?"

"Every bear market is ruthless."

I appreciated the perspective of all of these commenters in sharing their views on what a bear market means to them. But from my own personal and professional perspective, I disagree with this conclusion that all bear markets are ruthless. Instead, I believe they range from the tame "teddy" variety to the ferocious "grizzly" kind.

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For the purposes of this discussion and to keep things clean and simple at the start, let's begin by defining a bear market as a -20% decline in the S&P 500 Index (NYSEARCA:SPY) from a previous bull market peak on a daily closing basis.

By this already simplified measure alone we can run into debate, for some like to recognize the stretch from May 2, 2011 to October 4, 2011 as a bear market because the S&P 500 Index declined by -21.58% from peak to trough on an intraday basis over this five-month time period. But on a daily closing basis, the market declined by -19.39% from peak to trough. As a result, it is not widely recognized as a bear market.

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But this initial non-example begins to get at my point. If people are left to debate whether a bear market has even happened or not, it would not be considered ruthless or brutal by any stretch. And if we do slide it under the bar and call it a bear market, it would definitely be of the teddy bear variety. For not only was the magnitude of the decline very shallow at around -20% and the duration relatively short at just 5 months, nearly all of the declines took place over a much shorter time period of effectively 11 trading days in August. Put simply, if I can safely keep a gallon of milk in my fridge that lasts longer than the duration of a stock market decline, it is neither a ruthless "grizzly" or even a mild mannered "teddy" bear market in my view.

Now in working with the straightforward definition of a bear market as a -20% decline in the S&P 500 Index from a previous bull market peak on a daily closing basis, we have had 25 official bear markets take place as measured by the S&P 500 Index over the past 90 years.

The Teddy Bear Markets - Not Ruthless

Those that I would describe as the milder teddy bear variety are the following. The magnitude of the decline is relatively shallow in the range of -20% to -30%. The duration of the decline is also relatively short in moving from peak to trough in as short as a few months to as long as about a year. And as an added smart bow tie for the neck of these cuddly bears, the subsequent bull rally following the bear market bottom is swift and very forgiving where in the process much if not all of the decline is quickly recovered by investors.

The following are just a few examples of these friendly and tame bear markets over the years.

Although the bear market from August 2, 1956 to October 22, 1957 officially lasted nearly 15 months, in reality the bear market started on July 15, 1957, as the S&P 500 Index at 49.13 that day came within 0.51 points of its 49.64 all-time high from the previous August before heading lower. And it was only over the course of the next three months that the stock market fell by a relatively mild -21.63% before bottoming on October 22, 1957. And in less than a year after the bear market bottom in September 1958, stocks were breaking out to new all-time highs.

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Similar teddy bear markets took place in 1961-62 and 1966 to name a few. Even the notorious stock market crash of 1987 would fall in the teddy bear market category. For while it was one hell of a bad day on October 19, 1987, everything that followed after it was effectively nothing other than an upside ride higher.

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The Grizzly Bear Markets - Ruthless By Nature

A number of other 25 bear markets that might otherwise be described as the teddy variety have taken place over the past 90 years. These include the five-month bear market from November 1938 to April 1939 when the S&P 500 declined from its previous "bull market" peak by -24.44% -- both short and shallow. Another would be the two-month bear market from January 2009 to early March 2009 when the S&P 500 declined from its previous 'bull market' peak by -27.62% -- once again very short and fairly shallow. But as evidenced by the second example in particular, these "bear markets" share a notable distinction in that they are taking place within the time frame of what are widely known as some of the worst bear markets in history.

These are the grizzly bear markets. And these can be ruthless. Not devastating or terminal by any means, mind you. But cruel, harsh and seemingly unrelenting in its determination to move to the downside.

The grizzly bear markets are the big ones. They are deep in magnitude with declines easily in excess of -30% and more often in the range of -40% to -60% if not more. And they are also long in duration, lasting over the course of several years.

Historical examples of grizzly bear markets are well known. Classics such as 1929-1932, 1937-1942, 1973-1974, 2000-2002 and 2007-2009. All stretched over the course of multiple years and resulted in declines of around -50% or more.

The prospect of another grizzly bear market may be frightening to many. But as we learned in every instance in the past, it is the consequence of having asset prices that are either unjustifiably or artificially inflated beyond reasonable comprehension amid excess and often debt fueled speculative activity. For example, if global central banks believe it is a good idea to artificially inflate asset prices to among the highest valuation levels in market history as they have today without sound underlying fundamental economic support, they end up setting it up for the high probability of a grizzly bear market once they exhaust their monetary firepower. In such an environment, the more the market gets pumped higher in this manner, the angrier the grizzly bear market is likely to end up being. After all, if the stock market crash started taking place in October 1928 instead of October 1929, and if the tech bubble had been allowed to start bursting in October 1998 instead of March 2000, the aftermath might have been measurably less severe.

Embrace The Ruthlessness

Many shudder simply at the thought of another stock market cycle like 2000-2002 or 2007-2009. Just because a bear market in stocks could end up being ruthless does not mean that you need to fear it. For as long as the fate of the global financial system is not imperiled, and I absolutely do not think this will be the case with any future bear market as central bankers along with complacent-to-date fiscal policy makers have more than adequate resources to keep the global financial machine plugging along, grizzly bear markets will come with abundant opportunities.

The key is to not be asleep at the wheel thinking that a buy-and-hold stock portfolio will enable you to sleep at night. For if anyone is 100% allocated to the stock market with the belief that they will simply ride through any future bear market storm, it is likely that such a strategy will bring with it great and extended discomfort before it is all said and done. For while the most recent examples in the bear markets from 2000-2002 and 2007-2009 were certainly traumatic, they were also relatively short in duration lived thanks to extraordinarily aggressive monetary policy. The absence of such extraordinary aggressiveness this time around is likely to make the next bear market last quite a bit longer than those that have preceded it since the start of the new millennium, particularly if central bankers try too hard to fight the corrective process next time around.

Instead of trying to ignore the potential for a future bear market, particularly if it is indeed another grizzly, it is far better to embrace it.

Let's reflect on recent history to highlight how a grizzly bear market in stocks can be your friend and not your foe.

Consider the Treasury bond investor (NYSEARCA:TLT) during the financial crisis. Exactly what bear market are you taking about, they might ask? For while the stock market was seemingly tumbling into the abyss from July 2007 to March 2009, the long-term U.S. Treasury market was soaring with gains in excess of +50% at points along the way.

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Or consider the gold investor (NYSEARCA:GLD) during this same financial crisis time period. Twice along the way gold (NYSEARCA:PHYS) experienced a cumulative gain approaching 50% during this difficult time period for stock investors.

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Or consider the investor that incorporated more aggressive stock market hedges into their overall portfolio allocation during the financial crisis period. For example, an investor holding an allocation to some of the exchange traded volatility instruments available in today's market (NYSEARCA:VXX) could have generated gains well into the triple-digits on these holdings, which can add measurable value to overall portfolio returns with even just a trace allocation in an overall strategy if timed correctly. Once again for emphasis, this is a trace allocation at a very few percentage points at most and likely better suited for the more aggressive and nimble investor where deemed appropriate after some degree of professional review and oversight.

One More Reason To Love The Grizzly

What about the investor that wishes to stick purely with stocks. These are the times when holding cash is certainly useful. For just as an investor suffers by holding cash and generating a +0.1% return in a steadily rising bull market, they benefit from holding cash and generating a +0.1% in a bear market where meaningful price declines are taking place. This is because the price of the assets that they wish to buy with this cash are going on sale.

What makes this even better is that stock prices almost never fall in a straight line during bear markets. Instead, dramatic stock market declines are often followed by impressive stock market rallies. In short, if you have a disciplined and tested trading strategy in place, the opportunity exists to trade within a bear market by working to capitalize on these swift rallies while either sidestepping or also trying to capitalize on the sharp declines.

The following two charts highlight this point.

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During the bursting of the technology bubble, the market regularly experienced short-term rallies in the range of +8% and +22% as it made its prolonged descent from March 2000 to its October 2002 lows.

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And during the financial crisis, the market once again regularly experienced rallies in the range of +8% to 20% during its gripping decline from July 2007 to its March 2009 lows.

This is not to suggest that capitalizing on such trades is easily done. But they are available for the taking during bear markets. Those that have a plan in place to seek to capitalize on at least some of them will fare far better in this regard than the investor that has no such plan. And if the next bear market ends up being a grizzly even longer than the previous two, such a strategy may prove worthwhile while waiting for a final bottom. For one cannot help but look at both of these charts above and see similar patterns that define these past two bear markets that were sparked by very different causes. And these same patterns can be found in all of the other past grizzly bear markets regardless of their depth or duration.

The Bottom Line

A bear market need not be ruthless, but it is likely that the next one is shaping up to be a grizzly and not a teddy. But if it does turn out to be of the more ferocious variety, do not fear it as it does not imply impending doom. Embrace it instead and have a plan at the ready if and when the time finally does arrive. For not only can one capitalize on a grizzly bear market by allocating to other uncorrelated and negative correlated asset classes outside of stocks, they can also work to capitalize on the movements of the stock market itself as it progresses on its trip lower. And perhaps the best characteristic of all of a grizzly bear market is the deeply discounted stock prices that one finds once the bear finally bottoms and decides to head back into hibernation. This is arguably the greatest reward of all in having a sound bear market strategy in place.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT,PHYS.

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.