Bear Market Definition:
A bear market is defined as an event where asset prices decline in excess of 20% for at least 60 days. In contrast, if a decline in asset prices in excess of 20% occurs for less than 60 days this is referred to as a “market correction”. Bear markets are not permanent, and just like bull markets, are part of market cycles where investors pursue price discovery.
What Is A Bear Market: Bull Market Gains Repossessed
When defining bear markets in relation to equity markets, statistically stocks increase in value most of the time. As we have reviewed in a previous article titled “Why Are Stocks Going Up?“:
The S&P 500 on average outperforms inflation by 3% per year.
Therefore, you might wonder why anyone cares about bear markets if the S&P 500 has historically always rebounded from them during bull markets. The chart below, authored by James Stack, reviews the percentage of bull market gains that have been repossessed by bear markets.
On average, judging by this chart depicting bear market cycles dating back to the 1930s, it is prudent to anticipate that at least half of the bull market gains will be wiped away during a bear market. While the nature of capital gains taxes complicates the idea of timing bull market peaks, given that no one has a precise measurement of the future, rebalancing a portfolio when valuations are overstretched to include counter cyclical assets that have a negative correlation to equity markets becomes a prudent alternative than completely avoiding all equity exposure in hopes of timing the peak of a bull market perfectly. Therefore it is often costlier to not be invested in equities, which are by definition the riskiest form of ownership that provide both increased upside and downside, than it is to attempt to time markets.
Bull vs Bear: Not Every Market Gets Back To Even
Earlier we mentioned that historically the S&P 500 tends to increase in the long-term. That’s a U.S. centric perspective which hasn’t always been accurate globally. While many people like to think that bad things will never happen to them, the U.S. isn’t immune to the economic factors that effect other countries. U.S. firms are also highly levered to the performance of global economies, meaning if markets globally begin to falter, in spite of US economic performance, this could be a negative catalyst to experience a bear market in asset valuations.
The chart below is a scary realization that markets globally don’t always increase in value as much as the S&P 500. For example, the Stoxx Europe 600 index hasn’t moved higher in 17 years. Technically, we can’t say this moribund performance is permanent because we don’t know the future, but still 17 years of no gains invalidates the assumption that the S&P 500 will always go up.
The Stoxx 600 is far from the only index which hasn’t done well. It took from over 15 years for the Nasdaq to recover its losses after the tech bubble burst. The chart below is Japan’s Nikkei 225 which still hasn’t matched its 1990 peak. This should get the attention of those investors who dismiss valuations when stocks appear expensive. There’s no rule that stock valuations need to recover following a bear market.
Avoiding A Bear Market
Now that we thoroughly scared you with the perspective that not all bull markets recover following a bear market, in light of present all-time high valuations on US indexes, let’s look at how you can best avoid bear markets. The infographic below is great because it demonstrates the psychological change investors undergo, along with some of the sectors/markets to invest in at each time in the cycle.
The psychology of investing is probably the most misunderstood and important part of studying the business cycle. How can you not be amazed by investors piling into stocks as they get more expensive and then selling them when they get cheap? In other words, buying high and selling low. This is exactly the opposite of what that same person would do if they were buying anything other than equities or bonds. Think of your most recent shopping experience either at a grocery or department store and ask yourself if you are more likely to buy something on discount or if the price increases. If a company has a strong balance sheet, the long-term valuation of individual firms shouldn’t change as drastically as is often the case during bull and bear markets. The reason stocks can crash so quickly during a bear market is because investors are emotional and fearful. Fear and greed are probably the two controlling decision makers for most investors, though not the best investors. It’s difficult to think about long-term returns and short-term low valuations when your portfolio is down in excess of 20% as is the case in bear markets. Long-term thinking goes out the window and short-term survival instincts kick in. By contrast, when an investor is most fearful, it’s likely the best time to invest.
The two aspects of bear markets which make them difficult to position for, let alone profit from, are that they are tough to forecast and that your positioning will depend on what caused the crisis. For example, U.S. treasuries are typically bought in times of peril. However, if there’s a crisis emanating from the U.S. government debt, US treasuries may only act as a safe haven in the short-term simply because they are the most liquid market in the world, however in the long-term it would be a negative event for US treasuries which are not a guaranteed risk free investment.
Can You Predict A Bear Market?
Many confuse bear markets with being black swan events that cannot be predicted, however this is a faulty approach to investing. The economy, market, and nature itself move in cycles. Neither a bear market nor a bull market last forever and are actually the result of one another. That is to say, a bear market is the author of a bull market and a bull market is an author of bear market. Low valuations lead to increased demand, and high valuations lead to less demand.
A black swan is an unforeseen event which causes volatility in markets. It is always important to have a hedged portfolio that can help you withstand the potentially devastating effects of events that cannot be predicted, such as an accident. Statically, black swans are distribution curves with fat tails, meaning the end of the curve has a higher chance of occurring than a normal distribution. The chart below shows what we’re describing.
The green line has a fat tail as the risky scenario on the lower left has a higher than normal chance of occurring. Some people don’t believe in fat tails. They think every event was predictable. For example, the housing market crashed because the government encouraged people to buy houses and then the Federal Reserve raised rates, pulling the rug out from under the table. While you can extrapolate and anticipate certain outcomes, it is difficult to know the extent of the damage that this event could create for valuations. No one has a crystal ball. If this were the case, everyone would buy at the trough and sell at the peak.
Profiting From Both A Bull & Bear Market
The critical discipline to protect your portfolio through bull and bear markets is hedging. Hedging is when you start a position to avoid the risk of another position. For example, you can start a pair trade where you buy Microsoft and sell the IGV ETF which is a North American software exchanged traded fund. This trade would cause the investor to only be exposed to the out performance of the company, not the sector, thus diminishing the effects of macro level events to avoid systemic sector related risks. Another historically strong hedge for systemic risk has been gold, which we reviewed in “Is Gold A Good Investment?“.
The keyword when it comes to investing with the goal of minimizing risk is correlation. You want to buy assets with a low correlation to diversify against bear markets or black swans. The chart below shows the correlation of 5 year treasury yields to the US stock market.
As you can see, sometimes it has a negative correlation which means it acts in the opposite manner of the stock market. This is great for limiting the risk of an equity portfolio.
A few investments which typically do well in bear markets are cash, long term U.S. treasuries, the volatility index, gold, shorting the stock market, shorting high yield bonds, and buying safe sectors such as telecommunications and utilities. The charts below aim to measure the returns of some of the investments we mentioned to see which are the best to own. These charts look at the best investments in both bull and bear markets which is great because it’s difficult to predict when bear markets will start.
The 10 year treasury has the best performance, high yield credit total return swaps have the lowest standard deviation, and high yield credit TRS are the best for hedging. To be clear, CCC bonds are low rated junk bonds. The trade is underweight CCC bonds and overweight cash. CDX.HY are high yield derivatives and CDX.IG are investment grade derivatives. CDX.IG equity, is the most junior part of the investment grade option.
Bullish vs Bearish: Who Are You?
The end of this article got complicated, but to be frank, if we left our explanation of what to do in bear markets simple, then you’d leave here thinking it’s easy to hedge the risk bear markets pose. It’s very difficult to try to time the market or eliminate the correlation of your portfolio. That being said, don’t get lulled to sleep thinking the stock market will always go up forever during a bull market, just because the S&P 500 has done well in the past 100 years.