Market Adjustments: Learning to Love a Bear Market

I know Americans are concerned about the adjustments that are taking place in our financial markets.

– President Bush

Adjustment!

What on earth is a financial market “adjustment?”

Despite the sugar-coating, President Bush did get one thing right - Americans are concerned. More like afraid. Fear has taken over the markets. I’m loving every second of it, and you should be too.

The U.S. economy has plunged into recession. Unemployment has surged more than 50% in the past two years. Multi-billion dollar investment banks like Bear Stearns (BSC), Lehman Brothers (LEH), and Merrill Lynch (MER) that leveraged themselves against the housing market have disappeared (Goldman Sachs (GS) and Morgan Stanley (MS) may be following soon). Government sponsored enterprises Fannie Mae (FNM), Freddie Mac (FRE), and IndyMac (IMB) have been completely wiped away.

All the bad news has sent the major indices tumbling into bear market territory. Inexperienced investors are starting to feel helpless - and they’re starting to take action.

In July, investors pulled $23 billion out of stock mutual funds. In August, the sell off continued when mutual fund investors pulled out an additional $6.5 billion. The mutual fund redemptions undoubtedly just worsened the market’s decline.

When investors want their money back, mutual funds have to pay up. Normally they have plenty of cash on hand. However, when a lot of investors want their money back, as we’ve seen over the past two months, they have to sell shares to get the cash needed to pay back investors.

This is good news, though.

As a whole, mutual fund investors put money in and pull it back out at the worst possible time. The tech bubble is the perfect example. In 1999 and 2000, money flowed into technology-focused mutual funds. At the peak of the tech bubble in March of 2000, about 80% of all money in mutual funds was in the technology funds. All of that new money pushed the Nasdaq to a peak of more than 5,000.

When the downturn came, which it always does, the leading technology mutual funds lost 60% to 80% of their value as the Nasdaq plummeted back to 1,000. Moreover, most mutual fund investors weren’t selling out along the way.

Mutual fund investors waited and waited for a rebound to come. In typical fashion, most were unwilling to give up hope and take a loss at first. However, after the Nasdaq slid lower and lower each day over the next two years, they began to sell out.

As usual, they were selling at the worst possible time. In 2002 and 2003, when the major market indices were bottoming, mutual fund outflows were at their peaks.

It’s all just proof the herd is usually wrong. They buy at the top and sell at the bottom. That’s why I consider the recent surge in mutual funds redemptions a good thing.

Over the short-term, it just adds to the selling pressure in stocks. Over the long-term, it means there is a light at the end of the tunnel.

Although I expect more bad news from the financial sector, it’s tough to imagine it getting much worse. After all, when every forecaster is predicting “another shoe to drop,” chances are the markets are prepared for it.

So, I don’t think the end of the sell-off is over by any means, but I also don’t believe we’re headed for financial apocalypse. Over the next 12 months we’re going to get a lot of bad news and towards the end, we’ll start getting a bit of good economic news. There will be violent swings in the market along the way, but eventually, they will end. They always do - eventually.

In cases like this, when every pundit is calling for a crash, I try to step back and look at history. If you consider a bear market a drop in the Dow of 15% or more, there have been 25 bear markets in the past 110 years. Most of them have lasted between 12 and 24 months, and the average decline was between 20% and 40%.

If we consider this bear market started last October when the Dow last hit 14,000 we’re probably looking at between one and 13 months and possibly another 10% or so until we hit bottom.

The best possible thing to do now is learn to love bear markets. It’s the only time almost every stock goes on sale. And that’s the best time to buy.

Of course, I don’t recommend going “all in” today. Trying to time a bottom can be disastrous. However, right now, it’s more imperative than ever to have a plan.

I’ve set aside enough cash to buy consistently each month for the next 24 months. A 24-month plan should be exactly what is needed to make it through this bear market.

After all, right now there is a ton of money sitting on the sidelines. While investors have been bailing out of mutual funds as fast as possible, an additional $44 billion has flowed into money market funds with their brokers. As of August, a total of $3.5 trillion is sitting in money market funds.

The herd has moved into safe money markets in a big way. Once the markets start to show some signs of life, a big part of those money market funds will come back into stocks. It always does.

During “market adjustments,” when it seems like buying stocks is the worst thing to do, chances are it’s the best thing to do. As long as you have a plan (and stick to it), you can learn to love bear markets too.

 

Comments

[peterthepai...:]

it is difficult to fault this line..it nearly always works. my own feeling is that for the size of the problems out there the markets have hardly fallen at all yet. when people talk of peak to trough declines you have to remember that markets seamingly peaked last november on fed rate cuts and euphoria. a fall of 20% from there is nothing. the real falls will have to wait until after the election.

2008 Sep 17 06:24 AM

[mangolfer:]

Good article. As they say, "fear and greed drive the stock market".

2008 Sep 17 08:11 AM

[wpdragon:]

agree with painter... this market by rights should be at 8500 with all the huge shocks it has taken, and more to come here and abroad.

But it isn't. Why?

Because the fed has opened the discount window to the brokerages to the tune of hundreds of billions of $$ and they are daytrading it like crazy, whipping it up and down, taking a piece on each side of the trade... but always keeping a bid under the market when it gets down around 11,000.

11,000 is the line in the sand.. they keep their free discount window candy if they keep the dow around 11,000... that was their deal with the devil after Bear Stearns... the election is at stake if there is a 1987 style meltdown in the markets, for it would represent a pure and perfect exclamation point on the George Bush disaster that has been wrought on this country and the world at large.

Credit swap spreads at record highs today, Russia markets suspended trading last night for the second day in a row, China stocks melting down, the dow tanks 220 points at the open, then the choreographed Cox news on re-instituting the naked short rules... where were they the last 10 years when individual small and mid cap stocks were getting slammed by Goldman and Lehman and Merrill's dirty tricks hedge funds?????????????????...

Cox, and before him Pitt were nowhere to be seen, that's where, because it wasn't THEIR pals in the financials taking it on the chin, in fact they were CAUSING the losses to the little guy.

Call it the Plunge Protection Team, or the Invisible Hand, it exists and it will keep a bid under 11,000 until November 5 or die trying... but after that, say a prayer people, please say a prayer to whatever higher power you believe in.

2008 Sep 17 10:13 AM

[Joyful Alte...:]

dragon, you're most persuasive. Out here in the real world, the economy is slowly looking worse and worse. Houses not selling, no matter how low the prices go. Hiring freezes at the major employers. 401Ks are now 201Ks, and retirement has to be pushed back another decade, that is, if a job can be kept or found.

Yet, we have to pity the incoming president, because things will get worse before they get better. (Or with a President McCain, things won't ever get better, I suspect.)

2008 Sep 17 11:16 PM

[J-Texas-1:]

OK, here's the thing. Everything said in the article is true. But it's missing one big point: the higher they fly, the farther they fall. What is the historical market P/E and PEG? What are they in bear markets? Recessions and/or depressions? What are they when multiple bubbles of record sizes burst at the same time?

If I inflate the hot air balloon and rise to Mount Everest, only to lose my flame and fuel at the peak, do I fall just the first 7,000 feet (25%)? Or do I fall a lot further?

The Emperor has no clothes. Everyone's now admitting that. Who has confidence in an Emperor with no clothes? Who will abide by his country's rules after admitting to themselves that they were fooled for years?

Much bigger fall to come. Go back to historical bear market and depression-era valuations (for the remaining companies that will survive, of course). Use those approximate valuations to find the bottom.

After a capitulation, of course. The Emperor's subjects must rebel to purge their embarrassment and anger before we can move on.

2008 Sep 18 06:20 AM