The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.
What Exactly is a Bear Market?
A bear market occurs when the prices of investment instruments generally decline over an extended period.
The term bear market is most commonly used in stock trading but it can also refer to a negative environment for other securities like bonds or commodities.
The period of time when prices generally decline is referred to as the duration. Most bear market durations lasted more than one year but did not extend to more than two years. Available historical data reveal that a bear market duration ranged anywhere from a brief three months to a long three-year spell.
As a (smart) investor, how would you know if a bear market has started?
If you wait for the news to say it’s been declared a bear, the market may already be down 20%. By this time, it might be a little late.
When Has A Bear Market Started?
A good investor must be able to sense when a bear market is starting.
The signs to look for can include low earnings growth, rising interest rates, high market valuations, and geopolitical events. These things appear to be already present now (2018). For now, the market is still high, but things are changing quickly.
One must also be able to answer these important questions:
- What are the best mutual funds for a bear market?
- Are there certain types of stocks or bonds that flourish in a bear market?
- When should one prepare for a correction of the prices?
- What are the indicators that another bear market is coming?
You must also know your own status as an investor.
What were you before it started? What are you now?
Here are 8 keys to surviving in a bear market. Some of them will fit your investment style better than the others.
1. Use a Portfolio Hedge
Portfolio hedging is a technique designed to specifically protect you in a bear market situation.
The security hedges will normally move in the opposite direction of major indices. Portfolio hedges usually include financial derivatives (options and futures), negatively correlated ETFs, index options and short selling. Some of them may be effective for you or not. It all depends on your level of skill, knowledge and risk tolerance.
If done properly, hedging will offset some or even all of the losses in your portfolio.
Inversely, losses can be substantial if the market rallies because your hedges will move further in the opposite direction. Short selling may expose you to undeterminable risks.
2. Maintain Investment Balance using Tactical Asset Allocation
Plan how you want to structure your investment portfolio before you actually invest your funds in a bear market. This is a tactical part of your portfolio construction.
Let me explain:
As you may know, it is not wise to attempt timing the market by diving in and out stocks, bonds or mutual funds. A much smarter move would be to make small and deliberate adjustments in the asset allocation of your portfolio.
Asset allocation is the greatest catalyst of your total portfolio performance, especially over extended periods. An investor who is just average in terms of investment selection but good at asset allocation might have good returns. Conversely, an investor with a good investment selection but a poor asset allocation might have worse performance.
Let’s suppose that the indicators of a bear market are beginning to manifest: high P/E ratios, soaring interests. By all indications, a new bear market is just around the corner. You can already make a move to reduce your exposure to riskier stock funds and your overall stock portfolio. Begin building your bond fund and money market fund positions.
Let’s assume that your target or normal allocation is 65% stock funds, 30% bond funds, and 5% cash/money market funds. Once you see all the major signs of a bear market becoming present, you may want to adjust your allocation.
You can take mitigate risk by reallocating 50% to stocks, 30% to bonds and 20% to cash funds (See the best “plan: B’s” to the money market). The next step would just simply be selecting the mutual fund types that can help reduce your investment risks.
3. Effect a Stop Loss Order
To protect your portfolio from further decline, a stop-loss order may be the solution.
What exactly is stop-loss order
It is an order to your broker to sell your stock once it falls to a certain level below the current price. When the stock price dips to the designated stop price, the broker will automatically execute the order.
You can hang on to your portfolio and just wait until the stocks hit the Stop price levels. You can also raise the Stops as the prices of securities go up. This way, you may even realize modest gains instead of a loss.
The downside is, there is really no assurance that your stocks will be sold at the indicated price. Once the stock prices hit the stop level, it already becomes a market order. If it is traded at the market and the price drops below the stop level, you will likely get a lower price. You can use more technical indicators such as support and resistance, trend lines, candlestick chart and volume in order to get the right decisions.
4. Monitor the P/E Ratio on the S&P 500 Index
Technically, the P/E Ratio tells you the amount of money you need to invest for each cent of the income of a particular stock.
As such, it is widely used by traders and investors in stock selection. Although it may not accurately predict short-term market fluctuations, it can give insights into the value and direction of equity prices. The P/E of the S&P 500 index is like a barometer to determine if stocks are overbought or oversold.
How do we know if the P/E Ratio high?
Historically, the average P/E Ratio for stocks since the 1870’s has been about 15.66. If you take the average price of the big-cap stocks in the index and divide that by the respective mean earnings, you get a corresponding P/E. This resulting ratio is called “the market’. If this P/E is significantly higher than 15.66 it would probably go down in the future. If it is lower than 15.66, you can expect it to rise.
A much simpler way to get the P/E Ratio of the S&P 500 Index is by a Google search or accessing an online quote for any of the best S&P 500 index funds.
5. Diversify Your Portfolio By Using Traditional Defensive Investments
In the bear market that followed after the dot-com bubble, the Information Technology sector absorbed most of the brunt.
Because IT companies were then trading at astronomical values. Similarly, in the last bear market that followed the financial crisis, it was the turn of the financial sector. The financial sector was sent reeling on the ropes because of subprime lending.
A few sectors are considered defensives because their businesses are non-cyclical and not easily affected by larger economic cycles. Examples of this are utilities, healthcare, FMCGs and pharmaceuticals.
Some investors park their money in them with the belief that it will be safe during the fall of a bear market. There may be some merit in that line of thought. During the bear market period from March 24, 2000 to October 9, 2002, this safe haven strategy proved its mettle. When the whole market was tanking, consumer staples rallied to 24.23% while healthcare only registered a marginal 6.92% fall.
Unfortunately, it doesn't promise a total escape
During the last bear market from October 9, 2007 to March 9, 2009 there was no escaping the fire.
Not a single type of portfolio was spared. Although consumer staples fell far less than their counterparts in the financial or industrial sector, the decline was severe. It would have wiped out a considerable portion of your portfolio should you have parked your money there.
In such a case, holding on to cold cash would have been better than putting your money in defensive stocks. This is why the whole “diversified portfolio” strategy is never ironclad.
It’s your decision.
6. Cash Out Totally Or Partially
You may opt to sell off all or only the most overvalued securities in your portfolio. This is a very drastic move, one that needs careful analysis and a good strategy.
Your momentary exit may spare you from the fear and worry of losing more money. The market may hit rock bottom without affecting you at all.
But, when do you go back in?
Good timing is everything. A good rally may be tempting but it may be a wrong time. Stick to your fundamentals and see why and when you should jump in again.
7. Go Against The Flow
Securities that went down the most are good buys only if there is a guarantee that they will recover first or quickly enough. Since there is no sure-fire way to tell, one has to have a strong determination to use this method.
You could probably nab some stocks that are selling for less than half of their previous values. However, you should be ready to accept the reality that they might still go down after you buy them.
The real discipline is in looking for the stocks that eventually recover well over the long term.
8. Do Nothing At All
This one is simple:
Stay put and just wait for the market to recover. Hopefully, your investments will still be intact and poised to grow.
A word of caution though: markets can take years to fully recover. The waiting game will test your patience so see if you are up to it (See common mistakes made by investors). Now that the whole bear market scenario has become clearer, what do you need to do?
You are in luck because my strategy works for both bull AND bear markets. There is no more need to diversify your portfolio or do some advanced number-crunching analysis.
A bear market is not to be taken lightly.
On the other hand, an investor equipped with the right strategies does not have to worry about it. Use any or a combination of the first seven strategies to survive a bear market. Who knows? You may even profit from it.