Battling The Bear

A bear market is usually defined as a market that has declined 20% or more. The measuring rule can be more specific, with some investors suggesting that a bear market is present when the market falls 20% from its recent high or all-time high, or when the market declines by 20% or more over at least a two-month period. In the US equities markets, bear markets of varying degrees have occurred every three to five years (again, depending on your measuring rule). Two of the biggest bear markets took place from 1929 to 1932, when the Dow Jones Industrial Average (DJIA) fell 89%, and from 1973 to 1974, when the DJIA fell 45%.

What causes bear markets? The flip answer is: bull markets. There is some truth in that statement, because when stock prices rise, setting new highs and generating outsized returns for investors, that triggers a reaction in investors. The pessimism of bear markets is, in part, a reaction to the enthusiasm of bull markets. Just as investors tend to continue buying stocks when prices are advancing and the economic future looks bright, so do investors sell stocks when prices begin declining and corporate profits start to shrink. Bear markets, unlike ordinary downturns, often become vicious downward spirals. Owners of stock are unable to get their asking price, so they must lower the price to draw buyers back into the market. In turn, buyers are hesitant to jump into a market that is already declining, so the stock prices continue to drop.

STRATEGIES FOR BEAR HUNTING

When planning for a bear market, there are several strategies you can employ. A major factor in choosing a strategy will be the time horizon for your investment. If you have 20 to 40 years before you begin withdrawing money from your investments, then perhaps your portfolio can sustain the kind of losses that bear markets bring. This is because in a 20- to 40-year time span, you are likely to recoup your losses.

In fact, the long-term investor may be afraid to act when the market turns bearish. Not wanting to miss out on the first stages of the next bull market advance, many long-term investors will leave their money in aggressive stock funds -- which are among the ones that suffer the greatest losses during bear markets. If your time horizon is long enough, this buy-and-hold approach can be a viable option. But be wary; this option assumes a great deal of risk. When the market falls 45%, as it did during the 1973-74 bear market, prices need to rebound by 90% just for you to break even. While markets recovering from bearish lows often rise with a great deal of momentum, they often have significant losses to recoup before breaking new ground.

However, if you are only a few years away from retiring, you will want to protect your investment gains as much as possible. You may not catch the beginning of the next bull advance, but you will have limited your losses. Here are some strategies to consider adopting when battling the bear market.

Diversification - If your portfolio is diversified among a number of asset types, you can maintain your assets without too much work. With the right mix of bonds, cash, and stocks, you will have a portfolio that should maintain a nice balance. If a big bear hits, you will still suffer losses, but the diversification of your portfolio should help keep you afloat. You can always change the asset allocation, too. Taking some money out of stocks and putting it into cash or bonds while the stock market is declining can be extremely beneficial.

Some funds do the work of diversification for investors. Balanced funds usually feature a mix of stocks, bonds, and cash, which means less volatility than completely equity-based funds. Balanced funds will not regularly outperform equity funds in bull markets, but in bear markets, balanced funds can surprise investors with their ability to achieve high returns through investments in fixed-income products like bonds, dividend-paying stocks, and other investments that have a negative correlation with growth stocks (especially technology stocks) such as real estate investment trusts (REITS). Equity-income, growth and income, and utility funds are excellent sources for stocks with large dividends, while value funds, especially small-cap value funds, have often performed well during market declines.

Cash - When investors say "cash," they don't mean the greenbacks in your wallet. From an investing standpoint, cash refers to instruments such as certificates of deposit, savings accounts, Treasury notes, and money markets. If you're really worried about declines in the stock market, then you can protect your capital by investing in these insured instruments. And if the next bear market is fierce and relentless, as it was in the 1970s, those who have invested in cash will be among the clear winners.

Bear funds - You can ensure your aggressive stock funds during bear markets by buying bear funds. As the name implies, bear funds are designed for the chronic downturns and short-lived rallies that are the hallmark of bear markets. How do bear funds work? By anticipating declines, bear fund managers sell stocks short -- selling borrowed shares before prices fall, then replacing the borrowed shares with less-expensive ones and collecting the difference as profit. Bear funds can be risky, but they can offer some degree of insurance by providing positive returns in the event your aggressive stock funds are doing poorly.

Morningstar, the mutual fund research company, developed a statistic for measuring a fund's susceptibility to a bear market. The statistic, known as the "Bear Decile Rank," examines bearish months over the past five years and compares the fund's performance during those months. For purposes of their ranking system, Morningstar considers a bearish month to be one in which the Standard & Poor's 500 loses 3% or more. The top 10% of funds with the best performance are given the rank of 1, while the bottom 10% are given the rank of 10. You can learn more about the Bear Decile Rank at www.morningstar.com, and use it to narrow down your options. Having an idea of your fund options will help you when it's time to finalize an investment strategy.

By analyzing your investment objectives and time horizon, you can plan your strategy and be better prepared when the market takes a tumble.

EXAMPLE PORTFOLIOS

Here are a couple of asset allocation examples that could help prepare for bearish times. One example takes a conservative approach, while the other assumes a more aggressive stance.

 

Conservative: 50% Money market fund 25% Balanced 25% Fixed income fund; equity-income, growth and income, utility fund Aggressive: 50% S&P 500 index fund 25% Small-cap value fund 25% Cash or bonds

The aggressive example does provide some safety, with 25% of the money in cash or bonds. With 50% in the S&P 500, the portfolio is susceptible to a big hit, but it's also prepared for a bull turnaround. Theoretically, the small-cap value fund could be used to offset the losses of the S&P 500. It could also be interesting to replace the value fund with a bear fund, such as the Prudent Bear Fund (BEARX), which gained 25% from September 18, 2000, to December 18, 2000.

Figure 1 shows the performance of two portfolios following these investment allocation examples. In the period between September 18, 2000, and December 18, 2000, three bearish months for the S&P 500, both portfolios fared reasonably well. The conservative approach actually yielded some profit, while the aggressive approach offered some loss protection (many funds lost over 15% of their assets during this period). Because of the market decline in the last half of 2000, the conservative portfolio's one-year return was able to beat the aggressive portfolio's one-year return. All of the funds featured are no-load funds with a minimum initial investment of $3,000 or less.

FIGURE 1: EXAMPLE PORTFOLIOS FOR BESTING THE BEAR. Two different approaches for investing during a bear market.

WRAP-UP

Bear markets are going to happen. Understanding the warning signs of a bear market and having a strategy in place when the bear arrives can help you limit your losses, control your emotions, and put your investments in a better position for the next bull ride.

There are many options to consider when anticipating a bear market. If you have a short time horizon for your investments, you will want to protect your assets with a conservative approach that includes cash, bonds, or maybe even some income-producing stocks.

If your time horizon is longer, you have more options because time is on your side. Look for some diversification with bonds, service stocks, utilities, value funds, cash, or even bear funds if you're looking for some extra protection.