How to survive a bear market

The 1990s were actually quite unusual in that we did not experience one instance in which markets fell by more than 20 per cent. On average, we experience bear markets every six or seven years, and therefore they should be considered a normal part of equity investing.

Keeping the statement above and gaining a deeper understanding of bear markets may help investors maintain their resolve, and act rationally rather than emotionally.

The current bear market is proving to be particularly severe. From their historic highs to June 30, 2002, markets were down 36 per cent for the MSCI World Index, 35 per cent for the US (S&P500 index), a whopping 71 per cent for the technology-laden NASDAQ index (a good illustration of the risks of not diversifying) and the FTSE Eurotop 300 was off 37 per cent.

Although the Australian market has not been in such bad shape, it fell by nearly eight per cent since reaching a record high in March 2002. Although the Australian sharemarket is down only 4.5 per cent for the year to June 30, 2002, and is one of the few markets to record a positive return (up 2.06 per cent) for the two years to 30 June, 2002.

US and European markets are now close to levels first reached in late 1997, so while there was an opportunity for the prescient investor to take massive profits in early 2000, the buy and hold investor has now gone longer than four years without seeing a positive return.

A look at previous bear markets helps place current conditions in context. We have examined the US market because it is a useful barometer of developed equity markets. The comparison reveals that we have seen worse markets, in 1932 and in 1973/74, but also numerous less severe bear markets. Table 1 illustrates how far the market (the S&P500 index) fell from its highs during these periods.

What causes bear markets? A bad economic environment? Indeed, solid economic conditions should lead to reasonable earnings growth, and this ought to be good for equity markets.

As we examine key economic data, we see that the current economic environment is relatively sound. The US and Europe experienced solid economic growth early in 2002 (spectacularly for the US, GDP growth during Q1 2002 was more than six per cent!), and even Japan is at last generating economic data suggestive of more robust times ahead. GDP growth forecasts globally suggest that this growth will continue.

Interest rates and inflation are low, US and European unemployment rates are modest, and consumer spending remains resilient. In Australia, the economy is growing at an annual rate of four per cent, with recent numbers showing a sharp jump in retail sales, strong imports and a smaller than expected drop in building approvals.

Corporate earnings announcements show a less clear-cut picture, but the overall earnings situation is expected to improve as economic growth generates more business activity.

Equity markets in the short-term are affected far more by sentiment than they are by fundamentals.

The more extreme the situation, the more sentiment asserts its dominance. There was no better example of this than the irrational exuberance of the late 1990s, which saw technology and telecommunications stocks rise to levels far in excess of any reasonable assessment of future earnings prospects. So what seems to be driving sentiment today?

Continued weakness in the technology and telecoms sectors following the bursting of the dot.com bubble.

Ongoing geopolitical uncertainty — markets are still jittery after September 11, and military operations in Afghanistan, the tension between India and Pakistan, and the continuing violence in the Middle East.

Accounting scandals — the incessant drip, drip, drip of scandalous news about accounting misdeeds — Enron, Tyco, WorldCom, and most recently Xerox — has been eroding the public’s confidence in corporate leaders, especially in America.

Equity market volatility makes for entertaining news coverage. Curiously, however, it seems that falling markets makes for more dramatic news than rising markets. Many investors might be surprised to know that during the week June 24-28, when both the WorldCom and Xerox accounting scandals were announced and the media was focusing on the heightened concern and volatility, the US, European and Japanese equity markets all rose. The provision by the media of a daily or even hourly diet of bad news can cloud an investor’s judgement and place too much focus on short-term events rather than on the attainment of longer-term financial goals.

Economic fundamentals create the environment driving valuations in equities in the long term. Sentiment determines valuations in equities in the short term. The key difference between fundamentals and sentiment is the speed with which they change. Economic fundamentals change only gradually, while sentiment can change dramatically very rapidly. This explains why timing equity markets is so difficult.

While recent market conditions have been difficult, they are not unprecedented. Every decade of the post-war period except the 1990s saw periods where markets failed to produce positive returns over four years. These lacklustre periods in markets were often followed by periods of quite good returns. Table 2 shows the returns, excluding dividends, over the one, three and five year periods immediately after the US market has experienced a four-year period of negative returns.

So the key question regarding the current bear market is when will the bounce back happen, and by how much? Are we in for an even longer bear market, such as that experienced during the Great Depression or the 1970s? Or are we likely to see recovery more rapidly, as in other bear markets? AsMoney Managementwent to press, the Dow-Jones experienced its single biggest gain in a day since the 1987 recovery climbing six per cent. Whether this marks the end of the bear, is yet to be seen.

We do know, however, that there are some important differences between current economic fundamentals and those in place during the Great Depression and in the 1970s. A key contributor to the Great Depression was a massive crisis in confidence in the banking and financial system, which led to the failure of many banks.

This led to the development of the many depositor protection mechanisms and improved banking controls that have been successful at protecting the banking system since the Depression. The bear market of the 1970s, on the other hand, happened in a period of economic stagnation accompanied by high inflation, high interest rates, and massive unemployment. This is in complete contrast to the much healthier and robust economic situation today.

The end of bear markets are often accompanied by very high trading volumes and high volatility. We may well still have some downward spikes remaining in the current bear market, and it is impossible to tell when sentiment will change. However, once sentiment changes, markets tend to recover so quickly that investors waiting to get back into markets will more than likely miss out on substantial returns.

A close look at the best 20 trading days over a decade invariably shows that they account for a large portion of the premium for investing in equities, and that a high proportion of these days occur very shortly after the worst 20 trading days. Therefore it is difficult to avoid the worst days but be invested during the best.

So two key questions for nervous investors to consider are “How important is it that I avoid any further losses, however short term?” and “Do I dare exit the markets and risk missing the upside?”

Opting not to sell equity holdings in a bear market does not mean that investors should be passive. On the contrary, this is an opportune and important time for investors to review their portfolio and their long-term investment objectives to ensure they are in line.

Taking advantage of depressed prices to create a well diversified portfolio, that minimises risk and maximises the potential for returns when the market begins to rise again, is a prudent bear market strategy. It is often only through the experience of a bear market that investors truly develop an appreciation for the benefits of diversification.

Surviving a bear market requires discipline and determination on the part of equity investors.

Act rationally and resist the emotions such as fear and panic when making financial decisions.

Despite strong fundamentals, sentiment is driving the market — sentiment can change at any time.

If sentiment can change at any time, it is critical to have a diversified and well-positioned portfolio to take advantage of a market recovery.

Alan Schoenheimer is FrankRussell’s Australian managingdirector.