Surviving a falling (bear) market

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There is an old joke on Wall Street and Bay Street. What are the 12 most common words that come out of a market professional’s mouth? “I know what I said, but, trust me, it’s different this time!”

And this time it is. At the peak of a typical business cycle, industries are operating at full capacity, unemployment is low, and inflationary pressures increase. Credit conditions begin to tighten as central banks raise interest rates and leading indicators, such as the stock market, signal a slowdown. In a bear market (which is generally defined as a decline of a broad market index of 20 per cent or more that lasts more than two months), investor sentiment turns pessimistic and usually confirms an economic slowdown.

The two-month rule is important because global markets have become increasingly linked to one another, and we have seen the phenomenal growth of sophisticated derivative products that have increased market volatility. Unexpected shocks in one financial market now spill over to other markets, both foreign and domestic. Hedge funds that command large flows of capital can move quickly to mitigate losses but can move back just as quickly.

So while the stock market may drop precipitously, the rebounds can be just as significant. For example, in the U.S., the Dow Jones Industrial Average (DJIA) hit an all time high on October 9, 2007. By March 10, 2008, the DJIA index had fallen 17.1 per cent but technically was not a bear market. After a brief 10 per cent rally, it turned down and fell to 11,215 on July 2, officially establishing a bear market.

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In Canada, the swings have been similar but have not established an official bear market. In the first 10 months of 2007, the S&P TSX composite index increased 13.3 per cent. In the next three months, it dropped 17 per cent and five months later, on June 18, 2008, it hit a closing high of 15,073, a rally of 24 per cent from the January low. Definitely not for the faint of heart. If history teaches us anything, it is that eventually the market will turn, providing investors with a great opportunity to recover losses incurred during the bear cycle.

Like all bear markets, this one has been brutal for some participants. After 85 years, Bear Stearns, one of Wall Street’s most venerable global investment banking firms, became victim to its participation in the sub-prime mortgage debacle. Prior to its collapse, the company’s stock traded as high as $133 per share and was eventually taken over by J.P. Morgan Chase for $10 per share.

While these times are painful to live through, there are several strategies you can employ to minimize the financial mishaps. Throwing in the towel and running to cash to wait for the bottom does not generally work because market psychology is working against you.

Make sure you have an appropriate asset allocation strategy. The average bear market in Canada lasts about 12 months and the longest one in the last forty years lasted from August 2000 until September 2002 or about 25 months. If your portfolio contains a mix of cash and short-term bonds, during the middle of a bear market, there will be great opportunities to acquire companies that have collapsed in price and then profit from the subsequent stock market recovery. You can use this same approach to acquire shares of some of your existing stocks and dollar cost average the purchase.

Adjust your portfolio away from cyclical stocks trading at high price-earning ratios to defensive, high dividend-earning ones. Historically, this included bank and insurance companies but, as I mentioned above, it’s different this time. Look at your own consumer patterns. Whether the economy is growing or contracting, people still consume certain goods and services.

For aggressive investors, there is the ability to short sell the marketplace and profit from declining stock prices. A short sale takes place when an investor sells 100 shares of XYZ Corp. at $20 without actually owning it. If XYZ Corp falls to $15, then the investor can close out his short position by buying 100 shares of stock. The investor has just locked in a 30 per cent return (less transactions and borrowing costs). Horizon Beta Pro offers a bear market exchange traded fund with the ability to profit from declining stock markets. For more information, go to www.hbpetfs.com but recognize that you should consult with a professional advisor before engaging in short selling strategies.

Be patient. The hardest thing to do in a bear market is to sit tight; however, it may prove to be the most worthwhile strategy. If you are just starting out, it will be especially difficult to watch the value of your investments erode. Long-term players know that broad diversification should minimize the effects. It doesn’t mean do nothing. If you have had some successes, sell some losers to minimize the tax impact on realized winners, wait more than 31 days, and reinvest back into ones you feel are important enough to own.

Focus on balance sheets and earnings. Economic and stock market downturns weed out less competitive and unprofitable businesses and industries. It’s a painful but necessary evil in a free market economy. For example, look at the mining industry. High-cost producers, or those with excessive debt, usually fall prey to bear markets. They either end up closing the mine or being taken over by a competitor with a stronger balance sheet. Also look at industries that have a competitive position, high barriers to entry, or a product that operates in a monopolistic or oligopolistic environment, such as pharmaceuticals that sell products with long patent protections or technology companies with a market niche that dominates their sector.

Last but not least, plan for the next bull market. If you buy into the belief that Asian economies will see a long-term sustained improvement in economic standards of living, there will be a large population sector with rising income and rising demand for food and consumer goods that better their lives. Canada should be a net beneficiary of this trend. We produce vast quantities of raw materials that are used to produce finished goods and, perhaps more importantly, oil, gas, and coal that consumers need to run their daily lives.  

If you are still having trouble, don’t fret: you are not alone. The best brains on Wall Street and Bay Street will suffer right beside you. Long-term investors try to ensure that their income needs are being satisfied by the asset allocation mix in their portfolio and ride out the price fluctuations until the end of the bear and the beginning of the next bull market. If you are having trouble sleeping at night, perhaps you should review your portfolio with a professional advisor, and if you would like a second opinion, feel free to contact me.