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It’s a Bear! Now What?

February 21, 2008 by  


By Bob Wood, MMNS

An almost daily conversation in the financial media debates whether or not the major stock market indices have fallen enough to qualify as bear market status. In a medium that seems to specialize in wasting viewers’ time with nonsense and meaningless noise, this debate does nothing to change that view.

Whether or not we are in a bear market should be readily apparent to anybody with an ounce of objectivity. The financial media’s confusion about this subject centers on distinguishing between short- and long-term trends.

Promoters of the stock market want us to focus on whatever does less damage to their premise: that the stock market produces nothing but winners over time. They exude ‘’ stocks for the long run’’ nonsense that sounds good but has little foundation in fact.

Actually, those “stocks for the long run” can just as well go down to zero as shoot higher over time. One look at the components of the Dow Jones Industrial average from 20, 30, or 50 years ago shows how many companies have gone out of business during those years.

One recent example is Enron, once one of the largest companies in the S&P 500, which went bust while taking hundreds of millions of dollars of investor savings into oblivion with it. And how many “once hot” internet stocks fell to zero during the first three years of the current secular bear market?

While financial media promoters prefer that you focus only on the short-term, the longer term is far more telling. Perhaps the CNBC optimists will resist any bear market talk until the major indices have fallen by 20% from their more recent highs.

To me, their argument is absolutely meaningless. That the S&P 500 is lower today than it was eight years ago tells us all we need to know. But adding more proof is that bond funds have produced larger gains over the past 10 years than stocks, as shown by that index.

A common expression is: those who lose the least during a bear market will be the winners. I believe that statement is flawed since some investors can find a way to profit regardless of how the market moves.

If history is any indicator, and assuredly it will be, this bear market will do great harm to a large number of investors. How that will happen was described clearly by John Hussman, manager of the Hussman Strategic Growth fund, in his most recent weekly commentary.

If you are attempting to manage your own accounts during the current bear market, Hussman’s weekly comments should be on your short list of things to read. His work can be found on his website, www.hussmanfunds.com. The following is his description of the thinking process of the investor who is in the process of losing a large amount of his life savings:

‘’This is a good time to review what bear markets look like, because even though our own focus is always on the prevailing Market Climate, an understanding of how such market periods evolve can be helpful in riding one out. As I wrote in April 2000, bear market psychology typically evolves something like this:

“This is my retirement money. I can’t afford to be out of the market anymore!”

“I don’t care about the price, just get me in!!”

“It’s a healthy correction”

“See, it’s already coming back, better buy more before the new highs”

“Alright, a retest. Add to the position – buy the dip”

“What a great move! Am I a genius or what?”

“Uh oh, another selloff. Well, we’re probably close to a bottom”

“New low? What’s going on?!!”

“Alright, it’s too late to sell here, I’ll get out on the next rally”

“Hey!! It’s coming back. Glad that’s over!”

“Another new low. But how much lower can it go?”

“No, really, how much lower can it go?”

“Good Grief! How much lower can it go?!?”

“There’s no way I’ll ever make this back!”

“This is my retirement money. I can’t afford to be in the market anymore!”

“I don’t care about the price, just get me out!!”

“The following are actual figures and headlines from the 1973-74 bear market. At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

“Suppose you own stock. You have decided to be a “long term investor.” Stock prices rise to a new all-time high. You feel vindicated. The economy looks great. Although market breadth has deteriorated, your commitment is firm. “I can’t afford to keep my life savings out of the stock market.” “Buy-and-hold” is your motto.

“Then, after a modest rise in interest rates, the market sells off -12.3% in just over 2 months time. Ouch. A correction. Buy on the dip. These things happen from time to time. You’re a long term investor. Buy-and-hold is your motto.

“Sure enough, prices recover. Somewhat. A 4.8% advance, but already, you think, you’re on your way to new highs again. Then, you lose it all in a -10.2% decline. Two months later, you’ve given back your advance, and you’re at a lower low. Alright, another correction. Maybe you buy on the dip. Bargain prices. Buy-and-hold is your motto.

“And it’s already paying off. A month later, you’re up 7.8% from the low. But then a -9.1% selloff takes your portfolio even lower than the first two drops. The market is down -19% overall. You start to question the amount of risk you’re taking, but how much lower can it go?

“Thank goodness. 15.8% advance over the next few months! Should have bought more on the last decline. Earnings are still growing strongly. You decide not to wait. You buy more on the advance, confident that you’ll be rewarded by new highs. Then the market plunges -20% over the following 4 weeks. You stare at your statement and feel sick. You’ve held on for a year and your reward is a new low in your portfolio. This really is a bear market.

“Now some volatility. Up 12% over a few months. Then you lose it all a few months later in another decline. Then another 11% advance, followed by a -12% plunge to a new low. Seven times now, you’ve seen your portfolio collapse by more than -10%. With every recovery, a fresh disappointment. And the months march on. It’s a year and a half since the peak. You’ve lost nearly 30% of your wealth. Price/earnings ratios look low, but they looked low before the last decline, too. But maybe it’s the bottom. After all, the average bear market takes stocks down about 30%. Holding your calculator, you realize how that works. A -30% decline wipes out a 43% gain. Didn’t really consider that at the top.

“Stocks rebound a little over the next month. Just 6%. You’re still clinging to the bottom. Then, the bottom drops out. Not just 10%, or 15%, but a real free-fall. Over the next 6 weeks your portfolio plunges by -27%. You’re another -23% down from the previous low! Almost 2 years of nothing but losses! Major ones. You’ve lost almost half your retirement, now. Half your life savings! And the economy has turned bad. Everybody knows that stocks were overpriced at the top! It was so obvious! Greed. Valuations were so high. Everyone was so optimistic. Why didn’t you see it at the time? You decide you can’t afford the risk. Sell half. See if things recover, then get back in.

“Well, prices do recover. More than 15%. But then you lose it all in another selloff! Another new low! The market has lost half its value! Nine major plunges. Nearly every one to a lower low, and getting worse. This market has no support. Where are the buyers going to come from in an economy like this? People are unemployed. They don’t have the income to invest! And certainly not in the stock market. The financial headlines trumpet “The Real Recession is Yet to Come”, and “The Coming Dividend Crisis.” Some of the less diversified mutual funds are down as much as -80% from their highs! 80%! Every $100 has collapsed to $20. If it could happen to them, it could still happen to you. This is too risky. After all, you think, “I can’t afford to keep my life savings in the stock market.”

“Better safe than sorry” is your motto.

“That’s what a bear market feels like, but we all have a tendency to forget. Though my impression is that the market is at less risk here than it was before the 1972-74 or 2000-2002 declines, it’s glib to believe that rich valuations on record profit margins can be fully corrected by a 15% market decline, after which stocks will again be off to the races. As always, we’ll take our evidence as it arrives.

Does Hussman’s description sound too familiar to you? If at any point in the near future you start to hear this conversation in your own head, do yourself a favor and quit while you’re behind only a little. Secular bear markets last longer than we think they will. What matters most is that the loss you have already taken is not so big that it alters your life plans for the future.

The stock market has always been a brutally difficult place to make money, even in the good times. This is not one of the good times. At a time like this, preserving your capital is more important than growing it. Play defense!

Have a great week.
Bob

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

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