With the Market at New Highs, How Should You Prepare for the Bear?

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As of today (July 2nd, 2014), the Dow and the S&P 500 Index are flirting with new highs of 17,000 and 2,000, respectively. Both have come a long way from their low points of March 9th, 2009 (6,547 for the Dow and 677 for the S&P 500). While all of us should be pleased with the recent bounty delivered by Mr. Market, we should not become complacent and assume that the bear will remain in hibernation indefinitely. While this article should absolutely not be interpreted as a bear market call, here are some essential facts about bear markets:

  1. A bear market is defined as at least a 20% drop from peak to trough. A 10% drop is merely a correction.
  2. There have been eleven of them since 1929, or about one every eight years. A list of nine noteworthy ones can be found here.  The most severe of them was the drop associated with the Great Depression in which the S&P 500 dropped by a crushing 86%. Of course, this drop occurred in the midst of some unique circumstances such as investors who were margined on a 10:1 ratio, meaning that they had borrowed $9 for every $1 of their own money.
  3. They range in duration from three months to three years, with an average of about twenty months.
  4. In every historical bear market, investors that held on through the low point were eventually made whole and then some. For the most recent bear market (2008-9), an investment in the S&P 500 Index has gained about 47% compared to its peak from October, 2007.
  5. In bear markets, stocks revert to their rightful owners (commonly attributed to JP Morgan)

We admit that the last point above is more opinion than fact, but in the face of the enormous pressure to capitulate by selling out when the media is full of doom and gloom, investors would do well to remember that they are the rightful owners of equities, and if it’s nothing other than simple pride that prevents them from selling, then so be it. Furthermore, if they can effectuate the transfer of equities from their non-rightful owners to themselves by buying them as part of rebalancing, then they are likely to be better off for it. The painting below summarizes what an investor should do in a bear market as well as in a frothy bull market.

So how should you prepare for the next bear market, whenever it may happen? For starters, it may help you to remember how you behaved in prior bear markets. For us, every bear market has been a learning experience both about ourselves and about how other investors behave. One exercise we have found helpful is to simply write down what you would do if you woke up tomorrow morning and saw that the market dropped by more than 20%. Those of us who are old enough will remember that such a day actually occurred on October 19, 1987 when both the Dow and the S&P 500 dropped by more than 20% with no single news story to explain it.

Our good friend Dan Wheeler, the retired Director of Financial Advisor Services and Dimensional Fund Advisors, suggested that investors and their advisors regularly go through a “fire drill” that would simulate what they would do in a bear market.  If you would like to learn more about how an IFA Wealth Advisor can help you capture the returns of the market by keeping you tied to the mast, an endeavor that is simple but not easy, please give us a call at 888-643-3133.