What to think about on the way up…
not on the way down.
It’s coming…
The economy has started to show signs of stress. But with stocks near all-time highs you may not want to hear about bear markets or the next crash.
But it’s coming…
And you need to think about it on the way up… not on the way down.
This problem plagues many people when they plan their finances. Our heads get filled with a hodgepodge of rules, strategies, and “facts” that were never proven by data.
We end up with a lot of random ideas. And our natural tendency is to stitch things together in order to create coherent views.
That’s one reason I love almanacs. For decades, I’ve enjoyed the Farmers’ Almanac and Jeffrey Hirsch’s Stock Trader’s Almanac. I’ve got a large collection of these going back to the 1980s.
They are full of statistics and trivia about what markets have done in the past.
Did you know that January tends to signal what will happen for the year? “Down” Januarys have led to a down market for the year with an 86.8% success rate since 1950, according to Hirsch’s almanac. (The market rose this January by 7.9%.)
The first five days of January, too, act as an earlier warning.
Now, those stats probably don’t matter. If the stock market tends to outperform every Tuesday in February historically, it’s likely just chance. There’s nothing behind it.
But an almanac can collect a lot of useful information. It can confirm patterns that you thought may have existed and show you what you need to watch out for.
Right now, you need to be planning for a bear market. A bear market, of course, is the label that traders use when stocks decline by 20% or more.
But if you start fiddling with charts or spreadsheets, you’ll find that popular definition to be worth little. After all, is it only 20% from an all-time high? That’s not very useful in a period like the one after 2009, when stocks took nearly a decade to reach new highs.
In spirit, we want to define a bear market as “a period of prolonged negativity in the stock market, of such a magnitude that you’d like to have a plan in place to prepare for it.”
In simple terms, if the market drops far, fast… or takes a lesser decline over a sustained period, then we’ll call that a bear market worth preparing for.
So let’s see the bear markets… We applied that definition to the S&P 500 Index (rather than the Dow Jones Industrial Average) to get a broader gauge of the market. Here’s the chart of bear markets since 1940, and the table of bull and bear markets with their lengths and returns…
This tells us a few things…
First, markets climb slowly and for a long time, then correct quickly. The bad times last about one-quarter of the duration of the good times.
And one surprise jumped out at us… By our definition, the market decline that started last September qualified as a bear market. And then a new bull market was established from the market’s low on Christmas Eve 2018.
With our bear markets defined, we can go on to explore when they happen and what you can do about them…
In simple terms, if the market drops far, fast… or takes a lesser decline over a sustained period, then we’ll call that a bear market worth preparing for.
When the Bear Arrives
If you follow any financial news, you’ve likely heard dire warnings about the “yield curve” predicting a recession ahead.
This is an esoteric financial concept that you never hear about except when its value gets low and financial media need to gin up a headline. And you’ve likely never seen a full breakdown so you can judge its predictive power on its own.
The yield curve is the difference between the yields on fixed-income securities maturing at different times. You can use any expiration dates you’d like, though some have emerged to be the standard benchmark. The most common is the difference between 10-year and two-year bonds.
Normally, longer-dated bonds have higher yields than shorter-dated bonds. That’s called a “positively shaped yield curve.” The future 10 years from now is always more uncertain than two years from now, so you’re supposed to get a higher yield when you buy longer-term bonds to account for that risk.
But sometimes the yield curve “inverts,” and shorter-term bonds pay better yields than long-term ones. This happens when investors expect lower interest rates, lower inflation, or even deflation in the future. These things would normally happen only if the economy gets bad.
This “inverted yield curve” happened in late August…
So, does the yield curve predict recessions and bear markets? It’s not a good sign. When we see a recession, it’s likely that it was preceded by a negative yield curve. However, the yield curve also gives a lot of false signals.
Here’s what we can say for sure… the curve has inverted, and that means a bear market tends to come in the next few months. A recession follows a few months after that.
At the same time, we have to recognize we are in a unique time for monetary policy. The Federal Reserve over the past few years has been raising short-term rates. That could make an inverted yield curve a weaker signal than it has been in the past.
When things turn – as the economy slows and sales drop – the credit cycle can turn violently and lead to faster, bigger bear markets.
A Debt Collapse
You can get a bear market without a debt crisis, but you can’t have a debt crisis without a bear market.
Debt moves in cycles. When times are good, money is cheap. Lenders are willing to lend. As times stay good, lenders forget discipline and convince themselves that times will always be good. They eventually lend to folks they shouldn’t lend to… on terms they shouldn’t accept.
The worst loans are made at the best of times.
When things turn – as the economy slows and sales drop – the credit cycle can turn violently and lead to faster, bigger bear markets.
Right now, plenty of businesses can’t pay back their debts when they come due. However, the market believes that they’ll be able to find a new round of borrowing to pay off that debt and move it down the line. But when the credit cycle turns, lending standards tighten. Indebted businesses can’t refinance, and those businesses go from profitable to bankrupt.
Debt problems can come from consumer, government, or corporate debt. We’ll use corporate debt as our proxy here. We’re watching the debt cycle…
What you should note is that the biggest bear markets come attached to the biggest downturns in the credit cycle. The late-1980s, dot-com, and housing bubbles led to some of the biggest declines in our bear market table. The ones in between are smaller.
The first cracks in the credit cycle will show up here. The Federal Reserve reports that 2.8% of banks today are tightening standards for commercial borrowers, and 6.4% of banks are keeping a closer eye on consumers… despite the fact that most banks have been loosening standards since 2010.
Debt problems can come from consumer, government, or corporate debt.
Protection Before a Bear Market Comes
We’ll focus on three ways to protect your investments from a bear market…
First, an impending bear market doesn’t mean you should sell all your stocks. Stocks have been the greatest wealth-building tool in all of history. But you might want to take a closer look at which ones you own.
We looked at the 11 broad sectors of the market and their performances over the last six bear markets…
As you can see, utilities, consumer staples, and health care stocks offer opportunities to safeguard your wealth. Aside from the global financial crisis, every other bear market has had some sectors that stayed near even, and some that even posted gains.
On the flip side, if the bear market is coming, then you want to avoid financials, tech stocks, and the consumer-discretionary sector.
It’s clear that holding safe sectors can pay off.
In addition, gold is often referred to as a safe haven during bear markets. It makes sense… Gold is a physical asset and has been a store of value for thousands of years. Gold coins were minted for commerce beginning around 550 BC.
No matter what happens to the economy, even if the banks collapse and our economic structure goes down in spirals, gold will always have value. Investors like the safety of gold.
The real knock against owning gold is that it’s not a productive asset. It doesn’t pay any yield. Your money just sits there, and that turns many folks away from it.
But when the economy and the market start to become hazardous, owning gold helps investors sleep better at night. And since there’s only a finite supply of gold, a steady demand keeps prices up.
That’s why I like to call gold a “chaos hedge.” I’ve long maintained that part of your portfolio belongs in gold as protection for when things in the economy get ugly.
Historically, the performance of gold proves that to be true.
The price of gold has only gone down once in the past seven bear markets.
The returns haven’t been spectacular, but eking out an 8% profit when other investors see their wealth get cut by a fourth is a win.
The question is: Will gold hold up during the next bear market?
First, it’s important to look at what really drives the price of gold. Gold is a commodity, but it’s different than other commodities. Unlike oil or platinum or soybeans, gold doesn’t have much real industrial use.
You can’t build a skyscraper out of gold. It can’t warm your home at night. It’s just a globally accepted store of value. And gold’s real value doesn’t change. Throughout history, an ounce of gold has been about equal to the price of a decent men’s suit.
What really drives the price of gold is the currency it’s valued in. When the dollar is strong in relation to other currencies, the price of gold goes down. And when the dollar weakens, the price of gold goes up.
With rising debt levels, investors may want fewer dollar-denominated bonds, which will reduce the demand for dollars. Also, with fears of slowing growth, the Federal Reserve may lower interest rates in the future to try and keep the economy afloat. That should cause the dollar to fall as well.
If history proves to be true, gold should be a safe spot to park your money during the next big market drop. And to look at the most recent data, when the stock market dropped 19% from October to December, gold tacked on 12%… and went on to rally 24.3%.
And finally, the third way to protect your investments against a bear market is to buy put options. By definition, put options are contracts that give buyers the right to sell a stock at a specified price.
You can think of put options as a form of insurance against your portfolio. You pay a premium for it. And just like with home or flood insurance, you hope you never have to use it. But when there is a disaster, you’re happy you have it.
The next chart shows the CBOE Volatility Index (“VIX”) – also known as the market’s “fear index” – and the monthly returns for the S&P 500.
The VIX is calculated by looking at how much people are paying for S&P 500 options expiring in the next two months. It gives us a sense of how wild investors expect the market swings to be over the next month or so.
When folks are fearful and want put-option protection, the cost of protection increases dramatically…
You can also see how a surge in volatility pushes up put premiums from the table below. The price of a put option on the S&P 500 can jump around 400% when volatility spikes.
But buying puts costs you money if the bear market doesn’t come. That’s why you need to keep any hedges very small. The thought here isn’t to get rich off a bear market collapse… You just want a little bit (1% or 2%) to smooth out your returns.
When folks are fearful and want put-option protection, the cost of protection increases dramatically…
Prepare for the Next Bear
With all this information about bear markets, what do we do?
The prescription for survival is rather simple…
Take a long-term view: If you have the luxury of investing for five or 10 years into the future, the next bear market will come and go before you need any cash. Make sure your mindset matches your time horizon, and don’t worry about what doesn’t matter.
Diversify with bonds: You need some ballast to keep your portfolio steady in tough times. Bonds give you the opportunity to earn returns and have capital ready to deploy. All you need is a high-quality mutual fund or exchange-traded fund like iShares iBoxx Investment Grade Corporate Bond Fund (LQD) or something that may be available in your retirement account like the Vanguard Total Bond Market Index Fund (BND) or the Fidelity Total Bond Fund (FTBFX).
Defensive sectors can preserve your wealth: Common sense tells you that utilities and health care stocks should provide protection. The data show they do. For conservative-sector stocks, look to companies like Berkshire Hathaway (BRK-B), Rollins (ROL), and the Invesco High Yield Equity Dividend Achievers Fund (PEY).
Gold can help: Don’t go overboard – since gold’s returns during healthy markets can disappoint – but having some gold in your portfolio can deliver some good news when everything else looks bad.
With worry over a potential bear market rising, we wanted to provide the data to prove which techniques can work.
As a doctor, I always took the time to explain the reasoning for different medications and the mechanisms that made them work. I’ve found that following advice blindly leads to stress, confusion, and poor coherence to treatment plans.
By understanding what bear markets are, what can protect us, and how exactly that works, we hope you’ll feel better prepared and more confident when the next shakeup comes.
Dr. David Eifrig worked in arbitrage and trading groups with major Wall Street investment banks, including Goldman Sachs, Chase Manhattan, and Yamaichi in Japan. In 1995, Dr. Eifrig retired from Wall Street, went to UNC-Chapel Hill medical school, and became an ophthalmologist.
Today, he publishes a 100% free daily e-letter on both health and wealth that shows readers how to live a millionaire lifestyle for far, far less.
