Investing in a bear market

I try to stay away from using technical terms and numbers in these articles, but stay with me on this one. Investing is about some things rising while others are falling, and trying to understand what the net result will be. Spot which things I identify at rising and which are falling and see if you agree; don't worry too much about the math.

Overall stock market returns are composed of three elements: company retained earnings, dividends paid out, and changes to the price to earnings ratio (P/E ratio). Earnings are typically steady, rising with inflation. Dividends have been reducing for the last 20 years as growth companies have dominated the technology fields. The biggest swings are in the P/E ratio, which can move from lows of around 8 to highs above 30.

Below are historical numbers from Ibbotson Associates for the period 1926 to 2006, together with my forecast for the next few years, gleaned from various sources.

                                   1926 to 2006                   2008 to 2013
   Earnings                         5.3%                               4.0%
+ Dividends                      4.4%                                2.3%
= Core return                    9.7%                                6.3%
+ P/E changes                  0.7%                                ???
= Total Return                10.4%                                 ???

The conditions for a bull market are: a) high, but declining interest rates, b) a low, but increasing P/E ratio (think back to 1982, the start of the last bull market). We don't have these conditions right now; we still have low interest rates and an above average P/E ratio, coming down from a highs of over 35 at the end of 1999. The P/E ratio will decline if there is increasing inflation or an increased risk of deflation.

I do not believe we are still in a bull market. I believe us to be in a secular bear market that began in year 2000. I believe the market will remain volatile, and that means high risk for the average retail investor.

In bear markets, the stock market goes up and then back down, often going nowhere over an extended period of time (the last such market was in the 1970's). Bear markets range in duration from 4 to 20 years. Usually, the P/E ratio will 'overshoot' to the low side before starting back up. If it does continue to fall, the negative P/E number will reduce the 6.3% core return. Thus I expect below average returns in the US market of around 4 to 6% for at least the next few years.

Rowing, not Sailing

Passive index investing in the US stock and bond markets works well in increasing (bull) markets, and may reduce losses in falling (bear) markets. However, our aim is not to just lose less money than others, but to increase our wealth. Diversification is the key to avoiding losses, and in current conditions that means diversifying out of the US stock and bond markets. It means more international investments and more alternative investments that are not correlated to our usual holdings. We want to participate in the upsides (the bullish counter trends in the secular bear market), but avoid the downsides when the bear takes over again. Instead of sailing along with the market, we need to be rowing against the prevailing winds.

I favor Exchange Traded Funds for their low fees and great variety of investment types. This allows me to properly diversify your portfolio in these volatile times.

Want to read more on secular market cycles? I recommend Ed Easterling's book "Unexpected Returns" and his website Crestmontresearch.com

Return to Free Info