06.11 Are You Ready for the Next Bear Market?

“I never buy within 20% of the [market’s] bottom or sell within 20% of the top, but there is a lot of money to be made in between.” – Bernard Baruch

We have been in a raging bull market since March 2009—over six years. The broad stock market measured by the Standard & Poor’s 500 (S&P 500) index is a hockey stick. This bull market is 62 months old, against an average 68 months and median 54 since 1871. Sometime, there will be a bear market, and it will wipe out a lot of gains.

A bear market is a drop in a broad market index of at least 20% from its peak and lasting three months or more. A bull market is a 50% or greater gain from the bear market low. Using the most well-known market index of performance, the Standard & Poor’s 500 (S&P 500), here are bull and bear market stats from 1871 to 2014:

Notice that bear markets erase substantial bull market profits. Plus, the average and median 37% bear market peak-to-trough decline requires a 59% gain—not 37%—to return to the prior peak. The most recent bear market from Oct. 9, 2007 to March 9, 2009 brought a 55% dive. Therefore, though the S&P 500 including dividends has risen 251% since the trough, the first 128% only recovered prior losses. The remaining 123% sounds good, except that from the Nov. 2007 peak to today, the overall annualized (average annual) return to an investor has been a mere 6.3%. Bear markets truly reset the clock, and back more than an hour.

Can we sell at highs and buy at lows? Baruch, a great investor, reminds us we can’t but that there are ways to do well while managing risk.

Shares of stock represent part ownership of a business, and businesses are bought and sold every day. Buyers and sellers must agree on what the business is worth. Just as their managements do, value investors—including yours truly—use finance principles to analyze a business’s value.

When a business is valued cheaply, it’s more likely to be bought by another. That gives stockholders downside protection and low-risk upside at the current stock price. Similarly, when the business’s valuation is beyond what any rational buyer would pay, it is less likely to be bought out, offering investors little downside protection. It doesn’t matter if a business is actually bought or sold by another; it matters that we have determined the likelihood and therefore our margin of safety in making the investment. We’ll rarely, if ever, find ourselves within the 20%, but we’ll make decisions based on analysis, not emotion.

Bull markets are opportunities to sell to the greedy and bears to buy from the fearful. Because ups and downs can last a long time, investors must be ultra-disciplined and endlessly patient. In the meantime, we bide our time, reinvest dividends, and keep some cash on hand to buy at the next sale.

The next bear market? Bring it on.

Tom Jacobs is Investment Advisor and Portfolio Manager with Dallas’s Echelon Investment Management. You can reach Tom for a consultation at tjacobs@echelonim.com.

Image Credit: Eva K/Wikimedia Commons