The Investment U e-Letter: Issue #679
Friday, June 1, 2007 Bear Market: How to Combat Bear Markets and the Cyclical Nature of the Stock Market
by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club The Dow has hit over 20 new all-time highs this year. Equity investors are enjoying the best of times. And spirits are running high. At the risk of sounding like the skunk at the garden party, I want to warn you today that there is a big grizzly ahead of us, sharpening his teeth and filing his claws. His goal is to destroy billions of dollars of stock market wealth - and perhaps your hopes and dreams, as well. Don't let him do it. And don't be complacent about bear markets, either. Let me remind you that I'm not a market timer. Under most circumstances, the market is neither highly undervalued nor grossly overvalued. (I believe that's the case today, too.) You can, on rare occasions, set aside your market neutral stance when the market is experiencing a period of extreme optimism or pessimism. That's when it pays to put on your contrarian hat and move against the crowd. However, history shows these opportunities only come along every decade or so. The Coming Bear Market Today the average U.S. stock sells for about 19 times trailing earnings. That's higher than average. High P/Es, however, don't necessarily indicate a bear market is just ahead. (Just as low P/Es don't always indicate a bull market is about to begin.) Besides, with interest rates and inflation low, a higher-than-average earnings ratio is exactly what you'd expect. So why am I confident a bear market lies ahead of us? Because that's how the stock market works. Equities tend to go through long advances that last 3 to 4 years on average. These bull markets are then interrupted by furious bear markets that last about a year and a half, scare the wits out of investors and take the market averages down 30% or so. I mention this, in part, because the current bull market was born on October 9, 2002. That's when the S&P 500 sank to a low of 776. Since then the market - with dividends reinvested - has essentially doubled. Clearly, this bull market is long in the tooth. At more than four-and-a-half years old, it could start hitting new highs with a walker. I'm not saying its time to play taps just yet. In the '90s, for example, the raging bull lasted almost a full decade. And this market is still climbing on good breadth and heavy volume. But rising and falling markets are as natural as the changing of the seasons. Many investors don't see it that way, unfortunately. How Investors React to Bear Markets I spent 16 years managing money for high net-worth individuals. I've spent the last seven writing about the financial markets for hundreds of thousands of readers. I know how investors can react to a bear market. And it isn't pretty. Here's what goes through the minds of many investors in a full-fledged bear market. - Stage 1: This downturn is just a bump in the road, a correction in an ongoing bull market. Surely, stocks will snap back. This smells like a buying opportunity.
- Stage 2: Whoa. This is a serious pullback. I'm not going to sell anything at these prices, but I'm not buying anything either. This doesn't smell like opportunity. This smells like last week's fish.
- Stage 3: I'm getting killed. I never imagined my great stocks could get hit like this. I've got to do something. I can't just sit here and watch my net worth melt away like a spring snowfall. I've got to sell.
Selling at the bottom doesn't feel good, especially in the luxury of hindsight. Yet investors will do it time and again. Why? Either they don't understand how markets work or, two, they're acting emotionally rather than rationally. First off, imagine how you would feel if the market dropped 40%. Are you truly a stoic who can remain calm and maintain a long-term perspective? Or would you look back and say you wish you'd taken steps to protect yourself? Then, by all means, protect yourself now - and not by retreating into cash. Protecting Your Investment Portfolio From Bear Markets Fortunately, there are many sensible things you can do now to gird yourself against the next bear market… - You can invest in less economically sensitive stocks, like utilities, food and drug companies and defense contractors.
- You can reduce your exposure to small-cap stocks, which tend to get harder hit in a market downturn. You can diversify into foreign markets that are less correlated with the U.S. market.
- You can spread your risk among bonds, real estate investment trusts, gold shares, and inflation-adjusted Treasuries.
- You can pay off your margin balance, if any.
- You can eliminate your more speculative holdings, as well as stock positions that are lagging the market.
- You can close out your call options.
- And, of course, you can run trailing stops behind your stocks to protect your principal and your profits.
Please don't tell yourself you'll do these things "eventually." Watching your stock portfolio take a serious hit and then asking "what do I do now?" is not intelligent risk-taking. You can still make plenty of money if this bull market gets a second wind (or a third one), simply by understanding the nature of equity investing and using a system that allows you unlimited upside potential while preserving and protecting your wealth. Most importantly, understand that there is surely a bear market ahead of us, just as there has been after every bull market. The rub is that no one knows exactly when it will make its appearance. So protect yourself now. And remember, too, that behind every bear market is yet another bull market. Good Investing, Alex Today's Investment U Crib Sheet - Trailing stops are used with every stock recommendation Alex makes in the Oxford Trading Portfolio. Here's why, and how to use this strategy to increase your overall return. Full story.
- To add a "less economically sensitive" company to your portfolio, take a look at this defense contractor. Its stock is ripping higher. And its CEO's latest move could give shares yet another short-term pop. Here's why.
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