From Richard Smith, Founder, TradeStops:
Are you ready for the next bear market? Have you thought about what it will be like… and how you’ll handle your portfolio when it comes?
If you haven’t given much thought to the topic, you aren’t alone. Most investors have little idea what to do in bear markets.
That’s why many investors get clobbered in bear markets — financially and emotionally — with devastating impact on their long-term retirement goals.
It’s a good idea to avoid that (obviously). The proper mindset was captured by Pericles, a Greek statesman from the fifth century BC, who said, “Our job is not to predict the future, but prepare for it.”
We don’t know when the next bear market will begin … and our job is not to guess. The current bull run for U.S. equities, which is now the longest in history by various measures, could yet keep going like the Energizer Bunny for three months … six months … even longer.
But sooner or later — and sooner is a real possibility — it will come to an end. And another bear market will come.
First Trust, a portfolio wealth manager, did a study of S&P 500 performance dating back to 1926. They divided the S&P 500’s performance into bull and bear market periods, and defined “bear market” as follows:
From when the index closes at least 20% down from its previous high close, through the lowest close reached after it has fallen 20% or more.
Based on that definition, the S&P 500 has seen eight separate bear markets since 1926. The average bear market length, according to First Trust, was 1.4 years. And the average cumulative loss was 41%.
The longest bear market, after the 1929 crash, was 2.8 years. The shortest, after the crash of 1987, was just three months.
Keep in mind, though, that First Trust measured from the point of 20% decline to the bottoming-out price. In terms of investor psychology, a bear market can feel like it’s longer, because the final bottom can only be determined with hindsight. Many consider the bear to be ongoing for months or even years after a new bull run has started.
What can we learn from this data?
The 17th century English philosopher Thomas Hobbes once described the life of man as “nasty, brutish, and short.” Fortunately the life of man has improved. But that’s still a good description of bear markets. Equity bear markets can be painful … and bloody … and they come to an end faster than most would expect.
We can also see that bear markets are potentially devastating for retirement assets. An average cumulative loss of 41 percent — not just on an individual stock holding, but for one’s entire nest egg — is a very tough pill to swallow.
Bear markets can also devastate mental capital, which is just as important as financial capital.
An investor’s mental capital represents their sense of well-being, their emotional resilience, and their ability to make wise decisions under pressure.
When financial capital is hit, investors lose money. But when mental capital is hit, they lose their nerve and their capacity to be rational, which is sometimes even worse.
For unprepared investors, the real pain of a bear market is not just the potential for a 41% haircut from start to finish. It is also in the magnification of losses through leverage and the lack of ability to bounce back when a new bull run begins.
Many investors use “leverage,” which essentially means adding borrowed money to their own capital in order to increase returns. (This isn’t an exotic concept. If your stock-trading account is qualified to use margin, as many are, that means you have the ability to buy $200 worth of stocks for every $100 in capital.)
Leverage becomes very popular toward the end of a long bull market run. As investors grow more confident, their willingness to use leverage increases. The amount of optimism and leverage tends to peak even as the bull run reaches its climax. This magnifies the pain of the bear market that follows.
Then too, when average investors experience bear markets, their mental capital is depleted. This takes away their capacity to react rationally and pursue solid opportunities once the bear market has ended.
This is why bear markets can extract a double or triple cost. Not only do they inflict harsh losses on a stock portfolio, they take away the capacity to generate returns in the next bull phase … which can then reinforce a sense of frustration and despair when the investor realizes a new bull run has taken off without them! It’s a truly vicious cycle.
That’s the bad news.
The good news is that, by having a rational plan and using the right tools, it’s possible to sidestep all of this — and to actually take advantage of the opportunities that bear markets create.
When a bear market comes, the investor’s first job is to preserve financial capital. This means “avoid losing too much money.” Their second job is to preserve mental capital. This means “avoid losing your nerve.”
As a side note, bear markets are where “buy-and-hold” strategies tend to fall apart, because the buy-and-hold approach is just too costly, both financially and mentally, in the face of the brutal losses.
It’s one thing to be confident in buy-and-hold when the major stock indices have been gently rising for years on end. But it’s another thing when the markets feel like a never-ending sea of red, and have felt that way for six months or more.
As it turns out, preserving financial capital and mental capital is a two-for-one deal. Investors can help preserve both by managing their risk, which means sizing positions properly and cutting off exposure to losses before they grow large.
This is where the benefit of having a plan comes in — as Pericles said, not predicting the future but preparing for it.
And to implement that plan (especially in a time of emotional stress), it’s helpful to have the right tools in place, and a sense of familiarity and comfort with those tools, so that you can make the right moves when the time comes.
Preserving financial and mental capital is a crucial step
You can do that by having a risk-management plan, which includes the tools to help manage and execute that plan. That’s where TradeStops comes in … our software is designed explicitly for this purpose (helping investors manage their risk). Sizing your positions properly is a big part. Having access to reliable signals that warn you when an individual stock (or the entire market) has turned is another big part.
There’s also another key step to surviving and thriving in bear markets: knowing when to get back in.
Buy-and-hold advocates tell investors to hold on like grim death when a bear market comes. They caution against getting out because, as the buy-and-hold advocates put it, “you’ll never know when to get back in.”
Except you can, in fact, “know when to get back in …” as long as you have a plan and the tools!
There are logical ways to define when a bear market is ending
There are also opportunities within bear markets where various industries, sectors and individual stocks are experiencing bull trends, regardless of what the broad market is doing.
With the right tools, you can identify these opportunities — not in a vague or squishy way, but as defined by signals (provided via easy-to-use software) that tell you the transition is real.
And this is the place where bear markets provide opportunity — not for all investors, but the ones who were prepared.
It is always the case, almost by definition, that tremendous opportunities are available in a bear market aftermath. That’s because most investors were ravaged by the claws of the bear … and were thus forced to sell at rock-bottom prices.
The biggest and most powerful bull runs begin the moment the bear market ends. Having a healthy supply of financial and mental capital in those situations is a huge advantage, indeed.
The below chart, via the Financial Times, shows the average duration of bull runs for the S&P 500 dating back to 1932. As you look at the numbers, remember that each of those big bull runs started when a prior bear market ended.
Being financially and mentally healthy at the end of a bear market — which means preserving financial and mental capital all throughout the course of the bear — is one of the best things you can do.
Coupled with that, you need the tools and the signals to alert you to new opportunities … both during the bear market’s duration (there are always stocks going up; this was even true in the 1930s) and especially when the new bull begins.
Investing in markets without a plan is like going on a road trip without any maps, or going into battle without knowing what kind of war you’re fighting. It doesn’t make much sense. And the plan itself then requires the tools with which to execute it. But if you do have a plan and the proper tools, the landscape looks very different.
This is especially true in the context of bear markets.
Providing you with the knowledge and the tools to craft a plan and execute on it — via software like TradeStops and Ideas by TradeSmith — is part of our mission to help the individual investor succeed. It’s the heart of what we’re all about.
Richard