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The Bear Is Back

February 14, 2008 by  


By Bob Wood, MMNS

For months now we’ve been enduring endless speculation about whether the U.S. is in a bull or a bear market for stocks. I think recent developments have put an end to the suspense. The bear is back, and I, for one, am happy about it.

This may sound odd to most readers, though the fact that I have been bearish for many months should come as no surprise. But while most investors think of bear markets as a time to lose money, that shouldn’t be the case at all!

The stock market doesn’t need to go steadily higher for investors to make money. In fact, the worst market environment is a one without a trend, where narrow trading ranges last for weeks or months. As long as the market is moving one way or another, the potential to profit exists.

I actually believe that better opportunities to profit occur during bear markets, since stocks often fall in price faster than they move up. And since fear tends to be a stronger motivator than greed, a bear market cycle creates a large selection to buy at great prices when the last of the ‘’weak hands’’ sells in disgust.

To clarify, note that the Nasdaq Composite average now sits at about 2,300. It peaked at just over 2,800 in late October 2007. Since a drop of 20% signifies bear market territory to many observers, we are at the very edge of entering the bear’s den. The other major averages, the Dow and S&P 500, are nursing losses of about 15% from their recent peaks, thus edging closer to the Nasdaq in bear-market territory.

Of course, the latter averages never actually entered bull market territory. The Nasdaq and S&P 500 are both lower today than they were at peak during the last secular bull market, which ended in early 2000. So our stock market has been in bear territory for nearly eight years!

Please look carefully again at that last paragraph. Add emphasis to the words ‘’our stock market.’’ I do not mean to imply that all markets are also suffering through secular bear markets. Many others, instead, are enjoying new all-time high prices after moving higher since Spring 2003.

This scenario goes to the heart of what I try to convey in this space every week and, alas, what so many investors seem to ignore — at great cost. Opportunity to profit in the markets always exists. But surviving during these long-term bear markets requires a lot of imagination. Successful investors must build and manage their portfolios in ways that are not advised by adherents to the widely used — and highly flawed — investment theories of the day, commonly known as Modern Portfolio Theory, asset allocation and diversification.

To their detriment, too many investors take the easy way out intellectually and allow themselves to enter a sort of torpor; they suffer through the ‘’stocks for the long run’’ nonsense and manage their investments as the academics preach. I ask again: do you know anyone who has steadily made money with stocks using these theories?

Over the past eight years, investors who allocated all of their savings into bond funds have made more money than those who loaded up on ‘’higher yielding’’ stocks. When accounting for inflation, the stock market has been a loser for an entire decade to date! Do you really believethat owning a nicely diversified portfolio featuring large allocations in ‘’core’’ domestic mutual funds has been a worthwhile strategy?

While that deeply flawed theory might work well during bull market cycles, it fails miserably when the bull cycle ends. Then, creativity plus awareness of the broad spectrum of opportunities are required. But how many investors are truly well prepared for those?

I like to use an analogy from the game of chess. Beginners learn to ‘’see the whole board’’ and calculate several ensuing moves. Knowing your options rather than honing in on a narrowly focused strategy is a recipe for losing. So it is with the stock market.

Few differences are apparent between bull and bear markets for those hoping to profit. By the time the current secular bear market ends, which may well be several years into the future, most seasoned investors will have become adept at investing in a bear market. I am guessing that shorting stocks, investing in bear market mutual funds and sitting on large piles of cash will become commonplace.

And when too many investors discover that money can be made on the short side, that winning play will end. Of course, short, counter-trend rallies to the upside will endure, causing pain among those who were doing so well on the short side, and the new bull market will be upon us. Isn’t that how it always ends?

But my point here is that just as much opportunity to profit exists in bear markets. The first and most obvious play is buying whatever tends to do well when stocks fall in price. This is one aspect of Modern Portfolio Theory that does hold some value: the concept of correlation.

When investors sour on domestic stocks, what alternatives do they seek — if past history repeats itself? Sure, bonds are an obvious choice. Precious metals are negatively correlated to stocks as are other commodities. Hasn’t that been the case over the past few years?

Buying shares in bear market mutual funds is a rather new option, developed near the end of the bull market of the late 1990s. While the Nasdaq is flirting with official bear market territory, mutual funds that work inversely to that index go up as much as the Nasdaq comes down. One option I use is the Rydex Inverse OTC Fund, but others are available.

Cash is another obvious choice, though, with the Fed recklessly printing money and now planning to drop it from helicopters in an effort to stimulate spending, this looks like wasting an asset to me. Offsetting your cash holdings with small allocations in inflation hedges like precious metals, energy and other commodities helps to balance the lost purchasing power of your cash hoard.

In my opinion, the best opportunity coming from bear markets in stocks is that, by the end of the secular run, stocks are thrown out rather indiscriminately by the crowd, and bargains abound for those who managed to preserve their capital.

In fact, bear markets can offer far more profit potential than bull markets. Famed investor Warren Buffett is often remembered for having sat patiently on cash during the early 1970s. The bargain holdings he amassed then are largely responsible for the massive wealth he has accumulated. Joseph P. Kennedy, Sr., when making a similar strategic move in the late 1920s, was one of the very few who had money available to take full advantage of what the crowd nervously threw out when the economy and the stock market cratered.

The biggest gains will belong to investors who see the situation as it really is, who preserve their capital during the bad times while the crowd chases the dips, and who have the uncommon nerve to jump back in when the crowd, fearing further losses, won’t go near the stock market.

Don’t fear the bear! When he knocks on your door, don’t slam it in his face and hide under a table. Invite him in, show him to the best seat in your house and offer him refreshments. He’s there to help you, not to hurt you. See things his way, and you may make far more money than you did during bull markets!

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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