Bear Market: Extreme Or Not Extreme, That Is The Question

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by: Save Money Retire Early

Summary

There is a widely held view that this bull market has gone on for quite a long time and a bear market is inevitable. It's only a matter of time.

We are long-term investors. If you are too and can hold on for at least 10 years, you will find our conclusion beneficial and perhaps comforting.

If the market pullback is less extreme, investing for two years before the top would result in similar or better returns than if we tried to time the market.

Many financial commentators have been saying a recession is coming; others have called for a bursting of a bubble. Our take is that if you are investing long-term money, then stay invested. As long as you can live for the next 10 years without touching your investments, you are better off riding the market all the way up, back down a bit, and catch the next wave up.

We will look at the Dow Jones Industrial Average, which can be traded with the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA).

If you are like us, we don't know when the "bubble" will burst; it could be tomorrow or it could be more than a year away. This article from Market Watch was very interesting.

"Consider what I found upon measuring the Dow Industrials' return during all bull markets since 1930. I relied on the bull-market calendar maintained by Ned Davis Research, eliminating from consideration the handful of bull markets that lasted less than six months. The Dow's annualized return in those bull markets' final three months was 49.6% on average. To put that into context, the Dow's annualized gain during all months of bull markets has averaged 37.4%."

Our analysis of the last four market busts

Leading up to the crash of 1987. The Dow peaked on Oct. 2, 1987, at 2,641, with an annual return of 48.3%.

When the market bubble completely burst 17 days later on Oct. 19, 1987, the name Black Monday was coined. The Dow closed at 1,739.

From the top, the Dow was down 34%. But only down 2% from a year earlier.

The market essentially gave up the last year of bull market returns when it crashed. If you could only time the market perfectly and sell at the top, right?

Easier said than done. Of course, for every share that is bought at the top, a share is sold at the top. But the "winners" are a lucky few.

And if you are wrong about the top of the market and the bulls keep pushing for another year or two. You could be giving up a lot of upside.

Is the benefit of buying at the bottom better than staying the course?

Let's examine the results from our table:

Source: Yahoo Finance; Author

Of course, it goes without saying that if you can invest $100, a year or two before the bottom, sell at the top, and buy at the bottom, you will be the most well off. But how confident can you be in timing the market exactly?

First scenario: If you had invested that $100 in the Dow for the entire period, your $100 would have grown to $198, crashed to $130, and grown again to $239 after five years.

Second scenario: If you bought $100 of the Dow, a year before the top of the market, after five years, you would have $179.

Third scenario: If instead you had $100 and decided to hold off for a market crash, and bought at the bottom, you would have $183 in five years. But miss the bottom by one day and your $183 turns into $173. Miss it by two days and now it's only worth $157. Staying invested is starting to look like a better and much easier strategy.

We crunched the numbers on three other busts. See the charts below:

Source: Yahoo Finance; Author

Source: Yahoo Finance; Author

Source: Yahoo Finance; Author

Source: Yahoo Finance; Author

In the summary table, we see that the average top to bottom is a loss of 36%. To recover to breakeven from a 36% loss would take a 56% gain from the bottom. Interestingly the two-year average return from the bottom is 56%.

We are investing for the next 30+ years; we are long-term investors. Losing out on two years of returns may hurt a little, but knowing that we're only missing two years on average is ok. If we tried to time the market, we might miss more than two years.

Emotions often get in the way of investing as well. Our anchoring bias may prevent us from ever getting into the market at all even in the event of a crash. We may not be patient enough or have the necessary attention to pick the bottom of the market.

A side note on your investing time horizon

While you may not have the same super-long investing horizon as we do, even 10 years is long enough to justify staying in the market. If 10 years is still too long, you may consider diversifying from an equity-heavy portfolio into a mix with fixed income.

When determining the mix of equity to fixed income, it is important to count other "guaranteed" sources of income as well. You should treat pension income as an equivalent to fixed income in your overall portfolio.

Let's say you have $1 million. Plus pension income of $20,000 per year. If bonds are paying 2%, you should treat the pension income as equal to $1 million in assets invested in fixed income.

Therefore, if you want a 50/50 equity to fixed income portfolio allocation, your $1 million would be fully invested in equities.

Your split of equity to fixed income is completely up to your risk profile; 50/50 is just an example.

An Important & Interesting Observation

If the market crashes with extreme force as it did between 2007 and 2009, the benefit of standing on the sidelines is evident. You have over 50% upside after five years if you can get it right.

However, in the event of a more muted deflating of the market like in 1998, the benefits of waiting for the bottom are less evident.

Even the more average looking bear markets of 1987 and 2000-2002 resulted in little market timing benefits.

Our evidence shows that if the market pullback is less extreme, investing for two years before the market top would result in similar or better returns than if we tried to time the market.

So the questions become:

When will a crash happen?

And

Will it be a huge crash like the Great Recession where the market dropped over 50% or a less extreme crash where the market pulls back 20-35%?

What reasons does the market have to crash 50%+ back to levels not seen since 2010?

Are companies going to see revenue and earnings slip by 50%?

Is capital going to become scarce and expensive?

Are the valuation multiples going to contract by 50%?

Are these catalysts going to be long term?

There are so many potential catalysts, more than anyone could try to predict.

Conclusion

Perhaps we will take some profits from some of our winners to free up some cash, nothing out of the ordinary. But for the most part, we are holding tight. In the event of a market crash, we will have a bit of cash to buy some companies, potentially cheaper than they are today. But we wouldn't necessarily count on it if the bulls push on for another year or more.

We will cap off with a quote from Warren Buffett:

"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

If you looked at the progress of your portfolio 10 years from now, you probably wouldn't even know if the stock market crashed or just kept chugging along. In our analysis above, the longest period from start to end is #4 for almost 10 years. During that period, the market was up 60% or about 4.8% CAGR excluding dividends. For our data set of 32 years, the market would have multiplied your money 16 times at 9% CAGR excluding dividends.

Source: Google Finance

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Disclosure: I/we 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.