Bear Market Investing

Summary

• Poses the three questions investors should ask themselves about bear-market investing.
• Discusses one way to time the market and considers the inherent difficulties of market timing.
• Considers different approaches to bear market investing.
• Looks at the differences between the most recent bear markets.

There is probably more disagreement about how to invest in stocks during a bear market than about anything else in investing. The disagreement centers around three fundamental points.

First, is it better to stick to the same strategy in a bear market as in a bull market simply because it’s impossible to predict when a bear market is going to start or end, and because you don’t want to miss the bounce? Or is it better to use some sort of market timing signal to switch strategies?

Second, do you put a significant portion of your money into cash or bonds or a hedge, or do you stay just as long as you were during the bull market?

Third, if you stay long, do you switch strategies? This depends on the answer to a related question: Can you learn anything about future bear market strategies from past bear markets, or is every bear market different?

I’ll tackle these questions one by one.

1. Market Timing

First, market timing is difficult and often unreliable. But the anonymous author behind the brilliant Philosophical Economics blog (his Twitter handle is Jesse Livermore, the name of a legendary investor of the early twentieth century who made and lost millions and committed suicide in 1940) came up with a terrific method. It’s well worth your while reading his post In Search of the Perfect Recession Indicator.

Basically, the strategy is to go long unless the unemployment rate is rising and the price trend is falling. Unemployment is rising if the reported rate is above its trailing twelve-month moving average and price trend is falling if the S&P 500 is below its trailing ten-month moving average. “Livermore” found that this indicator beats all others over the period from 1930 to 2016.

So let’s take a close look at how this indicator would have performed over the last forty years.

First of all, there are a large number of false signals. You would have had bear market signals on November 1, 1979 and April 1, 1980, both false, but only lasting a month. Then you would have been out of the market for the decline in late 1981 and early 1982. You would have remained long through the 1987 crash. You would have been hopping in and out of the market for several months in 1990, getting back in on February 1, 1991, then out again December 1 for a month.

You would have left the market on March 1, 2001, when the S&P 500 had already dropped a good 19%, gone back in on April 1, 2002, but just for one month, and finally re-entered on May 1, 2003. You would have then exited on December 1, 2007 and re-entered on July 1, 2009, missing the first four months of the recovery, when the S&P 500 gained 38% from its lowest point.

You would have remained long ever since, even through the almost bear markets of May through October 2011 and May 2015 through February 2016. Still, even with all these false signals, you would be well ahead of someone who stayed long the entire time, assuming that person was invested only in the S&P 500 instead of using a more profitable stock-picking system.

So, yes, market timing is possible. It’s not neat and clean, and it’s hardly foolproof, but, as “Jesse Livermore” has shown, it’s better than simply sticking with an index through thick and thin. And there are far more sophisticated methods of market timing than this one.

But here’s the conundrum. If it were possible to develop a market-timing scheme that enables investors to avoid most bear markets, why would nobody have come up with it forty or fifty years ago? Stock market indexes and the unemployment rate were both readily available in 1968. So why did nobody come up with this simple system back then?

The answer is complicated. As “Jesse Livermore” points out, the onset of the 1937 and 1945 recessions could not have been predicted by any of the commonly used recession indicators, including the unemployment rate, which only began to rise after the recession had begun and the bear market was well underway. And the strategy does not work very well in other countries, using their unemployment rate. In addition, it has frequently been the case that the onset of a bear market has been a cause of recession rather than the other way around.

But there’s also a question of logic. Let us pretend that the wisdom of the combined unemployment rate and S&P moving average crossover method of market timing were accepted by 75% of market participants, which would certainly be the case if it could be proven to have actually worked. And let’s say that in July of this year, the unemployment rate started rising, but the S&P 500 was still well above its ten-month moving average (this has happened a number of times over the last fifty years).

What would it take for enough market participants to sell their stocks to drive the S&P 500 below its ten-month moving average? Remember that 75% of market participants will believe that while the S&P 500 is still well above its moving average, no bear market will occur. Therefore, any dip in the S&P 500 will be eagerly bought by those market participants, and indeed no bear market will occur. In other words, any market-timing indicator that actually works and which depends on stock prices will render bear markets impossible.

The real cause of a bear market is fear, and market-timing confidence and fear are incompatible. So we can take this scenario to the next logical level: If 75% of market participants had faith in the “Jesse Livermore” method of market timing, those same 75% of market participants would soon conclude that a bear market will never happen (or if it did they could get out in time), and the bond market would collapse since stock market indexes would be more lucrative and just as safe.

Now let’s say, on the other hand, that a market-timing method were discovered that was completely independent of stock market prices. It instead relied purely on other economic indicators, and was proven to have predicted every single bear market since 1929. And let’s say that 75% of investors believed in it. In that case, as soon as the indicators gave the signal, an incredible crash would occur and stocks would lose practically all their value overnight.

As a result, most public companies would go bankrupt and the economy would go into a depression the likes of which the world has never seen. There would be, therefore, incredible efforts on the part of governments to jigger those economic indicators so that they would never indicate a bear market. (There may be some parallels here to quantitative easing.) Or perhaps the government would make it impossible to read those indicators by messing with the data or keeping it under wraps. No matter what, this scenario is nightmarish in the extreme, and could be the basis for an excellent dystopian story.

These two scenarios are pretty strong arguments against the existence of a generally acceptable (or proven) market-timing mechanism. If one existed, stock markets would cease to make sense.

2. Strategy In A Bear Market

Now let’s turn to the second question: In a bear market, do you put a significant portion of your money into cash or bonds or a hedge, or do you stay just as long as you were during the bull market?

If you’re investing using index funds and you’re confident you can get the re-entry point right, obviously you want to be out of the market during a bear market and putting your money in short strategies, cash, and/or bonds. If, on the other hand, you doubt your market-timing ability, or you’re confident in your stock-picking prowess, stay long or use a long-short strategy similar to the one hedge funds use.

Now I’ve backtested, using Portfolio123, the strategy that I use for my own stock picking - a microcap value-growth-and-quality strategy - and according to these backtests, it would have been a serious mistake to be out of the market during those periods.

Even if my returns had been only half of what my backtests tell me they’d have been (a reasonable assumption), I would have made a lot of money in the first of the millennium’s recessions, and while I would have lost a lot in the second, the recovery in 2009 was quick and dramatic. So that answers the question for me. While using a long-short strategy during both recessions would have made me more money, there are significant costs and risks involved, and timing the re-entry point is very important.

So the answer here depends on the answer to two other questions. Can you time the end of a bear market? And do you have a winning value-based strategy for stock picking that consistently beats the index?

3. What Do Bear Markets Have In Common?

Now for the third question: would a successful strategy for one bear market be successful in another?

Well, let’s create six different long-only strategies and test them out. I’m going to create ranking systems for a purely momentum strategy (with three factors), a size strategy (with two factors), a growth strategy (with three factors), and a value strategy (with four factors). The factors within each strategy will have equal weight. Then I’m going to combine two strategies, again equally weighted, at a time and test those against the S&P 500.

The stock universe I’ll test is all stocks on major US exchanges with a median three-month daily dollar volume of $100,000 or more, a minimum market cap of $25 million, and a minimum price of $1.00, excluding REITs and MLPs. The backtest consists of going long on the top-ranked fifty stocks and rebalancing monthly, with 0.5% slippage for each rebalance. I’ll use the conventional timing for the bear markets, 3/24/2000 to 10/9/2002 and 10/9/2007 to 3/9/2009.

Here are the results, which are not annualized:

As you can see, by far the best strategy in the 2001 recession was a growth and value strategy, while that would have failed miserably in the 2008 recession. By far, the best strategy in the 2008 recession was momentum and value, which did quite well in 2001; but a close second is the growth and momentum strategy, which would have fared miserably in 2001. All three value-based strategies would have done just fine in the 2001 recession, but in the 2008 recession, two of them would have underperformed the S&P 500. I haven’t tried it, but I suspect you’d find similar discrepancies if you added the almost-bear markets of 2011 and 2015.

Another way to look at bear markets is by sector performance. Lawrence Hamtil has helpfully broken down the last five bear markets by sector performance in his post Imagining the Next Bear Market - Part II. In the 1973-75 bear market, the best-performing sectors were energy, materials, and staples; in the 1980-82 bear market, they were industrials, materials, and telecom; in the 1990 bear market, they were health care and energy; in the 2001 bear market, they were staples, materials, and financials; and in the 2008, bear market they were staples, healthcare, and utilities.

In general, materials and staples performed the best, but materials did very badly in the most recent bear market. If you look at what sectors performed the worst, it’s all over the map. In the first bear market, it was discretionary and financials; in the second, it was energy (nothing else came close); in the third, it was discretionary and financials again; in the fourth, it was technology and telecom; and in the fifth, it was financials, industrials, and materials. In short, every bear market is very different.

Now as I’ve written in my Seeking Alpha article The Ideal Stock Evaluation System?, I’ve developed a stock evaluation system. If you had used that evaluation system, in the same universe as above, buying stocks ranked 98 or better, you would have beat the market handily in both of the most recent bear markets, earning a total of 100.42% (not annualized) in the 2001 recession and losing only 43.28% in the 2008 recession.

And a combined long-short strategy (shorting stocks ranked 2 or worse that are over $1 billion in market cap) would have done even better (if you don’t count interest and other costs): 3,363% in the 2001 recession (no, that’s not a typo: remember all those incredibly overvalued and utterly worthless stocks in 2000?) and a gain of 105.77% in the 2008 recession.

But this all depends on perfect timing. If you were a few months late in realizing that the bear market in stocks was over in March 2009 - for example, if you were relying on an end-of-month moving-average signal - you would have been better off not shorting anything at all. A long-short strategy was great in the 2001 bear market but only would have worked in the 2008 bear market given very good market-timing skills.

To conclude, the most logical approach, in my opinion, is to remain fully invested in stocks at all times using a sensible low-beta high-alpha stock-picking strategy that consistently beats the market. If you are comfortable with short-selling (I’m not), use the recession indicator that “Jesse Livermore” discussed and split your holdings between long and short positions during those periods, choosing your stocks wisely according to good fundamental techniques.

Another way to hedge during a bear market is to buy puts, which, I confess, I’m not sophisticated enough to discuss. If your retirement account doesn’t allow you to pick stocks, go to cash or bonds in that account during the periods that the unemployment moving average system outlines. And remember: there’s no way to characterize bear markets - each one is different. How a system performed in one bear market will tell you very little about how it will perform in the next.

Analyst’s 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. I have no business relationship with any company whose stock is mentioned in this article.