The new year started really ugly for the stock market. The S&P 500 Index is down almost 10 percent since the start of the year and January hasn’t even finished yet. Since the high recorded in May 2015, the index declined 13% and that provokes market watchers to speak of a bear market unfolding. Analysts view a bear market as a period where the broader market drops at least 20%. Before hitting that level, markets already show other characteristics than during a bull market (an extended period of price increases).
For investors it is important to realize the impact of changing market conditions. And that’s not only because of an opposite price direction. Volatility, or intensity of price fluctuations, increases during a bear market as well. Investors should reflect on the change in investment sentiment and on their own character. In addition an evaluation of the investment approach is required in order to prevent unbearable losses and to be able to sleep well at night.
1. Change your mindset and adapt
Price movements tend to be much more rapid in a bear market, whereas bull markets show most of the time a gradual increase over an extended period of time. This was strikingly visible during the last bear market on the US market. After five years of a rising market, share prices started to decline in October 2007 and a bear market that erased al previous gains (and some more) ended in March 2009, only 18 months later. The fierce movements during a bear market make clear that investors need to adapt quickly to the changing market characteristics in order to stay in front of the curve.
One of the largest distinctions between bull and bear markets is a change in risk tolerance. During bear markets, investors become more risk averse and want to cut their exposure in risky assets. Capital preservation becomes the key theme. That means market participants seek to protect their capital and take a risk-off approach. During a bull market, investors are looking for opportunities and are risk prone.
Fear is one of the most powerful human emotions. So if markets turn from a gradual increase to a potential bear market, reactions of investors are strong. Now some may say that institutional investors and automatic trading systems are not, or at least much less, affected by emotions. But since losses are the unwanted outcome of investment strategies, these investors and systems will adapt swiftly to prevent this outcome. Automatic trading systems are programmed to cut losses. During the ‘Flash Crash’ on May 6, 2010, so-called High-frequency trading systems were even turned off. A lot of HFTs are liquidity providers, with absence of these systems liquidity dries up. This leads to exaggerated price movements. So from a rational and irrational perspective, the increased intensity of a declining market, i.e. higher volatility, is perfectly explainable.
What does this mean for you as an investor? Be aware that changing market conditions require a different approach to the market. Understand that when the market perceives risk as more important over opportunity or yield, you need to change your mindset as well. That doesn’t implicate that you should follow the herd, but you have to adapt to the circumstances.
2. Reflect on what type of investor you are
First of all, bull or bear market, it is important that you are aware of your risk tolerance. Are you worried about losses or are you prepared to face losses in the short term and stick to the long term picture? Make no mistake, all investors hate losses and we all want to prevent them. Nevertheless, each investor has a specific level of risk tolerance and great investors (and in particular traders) distinct themselves in awareness of their risk tolerance. When you lose sleep over a volatile stock, you should consider a different stock selection. If you can’t stand 25% losses, consider a stop loss. If you’re afraid of financial ruin, your position is to large and you should reduce your position size.
Next to that, it’s important to reflect on your investment goal. Are you searching for opportunities, do you seek income from your capital or are you building funds for your retirement? Is it a passionate hobby or is it even your job? Your investment goal defines your risk tolerance, your stock selection and your investment horizon (more on that below).
But why is this reflection important for bear markets in particular? Your investment goal indicates how you should adapt. If you search for opportunities and therefore invest in high growth stocks, be aware that bear markets are not your type of market. Due to a switch of market sentiment to capital preservation, growth stocks are out of favor. This type of stocks will underperform and thus may show steeper declines than the rest of the market. Stocks with high ratios, such as stellar price/earnings or price/sales-ratios will get hammered since no-one is interested in speculative bets during a bear market. So when you’re specialized in growth stocks, bear markets may be a good moment to stay away from the market.
If you’re investing for income generation and your portfolio consists of dividend plays, you should worry less about price movement but focus more on company fundamentals to make sure dividends stay intact. Often bear markets occur in a weak macroeconomic environment marked by poor company results. Unless dividends are cut, you don’t have to be afraid for a bear market. It can even offer an opportunity to add shares to your portfolio at lower prices (and thus higher dividend yields). This opportunity in a bear market is also applicable if you invest for your retirement, although caution is required.
3. What is your investment horizon?
Investing for your retirement brings us to the third important consideration: your investment horizon. Historically, stocks and bonds show a significant outperformance compared to cash (adjusted for inflation). During the last 30 years, the average annual yield for the S&P500 Index was 11.7%. After a strong decline, the year that follows often shows above-average gains. For instance, after a more than 40% decline during the years 2000-2002, the S&P 500 rose with 28.7% in 2003. Also after the horrible year 2008 with a 37% loss for stock investors, the market rose with 26.5% in the following year.
The above shows that if you’re in it for the long run, a bear market shouldn’t bother you too much. A bear market can even offer opportunities for your retirement portfolio. Since prices come down, on the long run bear markets offer a good entry point. But make no mistake: this takes courage. Buying in bear markets often means that shortly after accumulating a position, prices will drop further. That causes losses on the short term, which could be significant if the bear market is long and deep. A solution is to accumulate in phases, for instance adding a bit after a 10% decline and a bit more later. But be aware of the risk of averaging down on a losing position. If the decline is due to concerns about the existence of the company, rather than temporarily headwinds and/or weaker sentiment, gradual accumulation at more attractive prices is not an option. As always, investors need to do their homework and lower prices do not automatically mean cheaper stocks!
When you have a short term horizon, bear markets may not be your type of market. A recovery in a bear market is the same as a correction in a bull market. That means a short term bounce within the larger trend. A bounce doesn’t offer a good investment opportunity. On the contrary, it often causes losses and frustration. Just like with growth-stocks, staying out of the market may be the best decision if you only play stocks for limited periods.
Conclusion: adapt or die
Sceptics and permabears may point to the bear market of Japan’s stock market that lasted for over a decade. Or to tech stocks, since Intel (INTC), Cisco (CSCO) and Microsoft (MSFT) still quote at lower levels than during the dotcom-hype over 15 years ago. This reminds us not to be complacent about an ever-increasing market and urges us to diversify our investment portfolio. But in the long run, investors are confronted with both bull and bear market. In order to survive a bear market, investors should be flexible and make necessary adjustments when market conditions change. Adapt, or lose your sleep or even your shirt.