Adapt To A Bear Market

Adapt To A Bear Market Witnessing a bear market for stocks doesn't have to be about suffering and loss, even though some cash losses may be unavoidable. Instead, investors should always try to see what is presented to them as an opportunity, a chance to learn about how markets respond to the events surrounding a bear market or any other extended period of dull returns. Read on to learn about how to weather a downturn.

What is a Bear Market?
The boilerplate definition says that any time broad stock market indexes fall more than 20% from a previous high, a bear market is in effect. Most economists will tell you that bear markets simply need to occur from time to time to "keep everyone honest". In other words, they are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and the combination of legislative and regulatory changes in the marketplace. Cyclical patterns of stock returns are just as evident in our past as the cyclical patterns of economic growth and unemployment that have been around for hundreds of years.

Bear markets can take a big bite out of the returns of long-term stockholders. If an investor could, by some miracle, avoid the downturns altogether while participating in all the upswings (bull markets), their returns would be spectacular - even better than Warren Buffet or Peter Lynch. While that kind of perfection is simply beyond reach, savvy investors can see far enough around the corner to make adjustments to their portfolios and spare themselves some losses.

These adjustments are a combination of asset allocation changes (moving out of stocks and into fixed income products) and switches within a stock portfolio itself.

When the Bear Comes Knocking
If it appears that a bear market could be around the corner, get your portfolio in order by identifying the relative risks of each holding, whether it's a single security, a mutual fund, or even hard assets like real estate and gold. In bear markets, the stocks most susceptible to falling are those that are richly valued based on current or future profits. This often translates into growth stocks (stocks with price-earnings ratios (P/E ratios) and earnings growth higher than market averages) falling in price.

Value stocks, meanwhile, may outperform the broad market indexes because of their lower P/E ratios and the perceived stability of earnings. Value stocks also often come with dividends, and this income becomes more precious in a downturn when equity growth disappears. Because value stocks tend to get ignored during bull runs in the market, there is often an influx of investor capital and general interest in these stodgy companies when markets turn sour.

Many young investors tend to focus on companies that have outsized earnings growth (and associated high valuations), operate in high-profile industries, or sell products with which they are personally familiar. There is absolutely nothing wrong with this strategy, but when markets begin to fall broadly, it is an excellent time to explore some lesser-known industries, companies and products. They may be stodgy, but the very traits that make them boring during the good times turn them into gems when the rain comes.

Seek Out Defensive Investments

In working to identify the potential risks in your portfolio, focus on company earnings as a barometer of risk. Companies that have been growing earnings at a fast clip probably have high P/Es to go with it. Also, companies that compete for consumers' discretionary income may have a harder time meeting earnings targets if the economy is turning south. Some industries that commonly fit the bill here include entertainment, travel, retailers and media companies.

You may decide to sell or trim some positions that have performed especially well compared to the market or its competitors in the industry. This would be a good time to do so; even though the company's prospects may remain intact, markets tend to drop regardless of merit. Even that "favorite stock" of yours deserves a strong look from the devil's advocate point of view.

Identify the Root Causes of Weakness

It may take some time for a consensus to form, but eventually there will be evidence of what ended up causing the bear market to occur. Rarely is one specific event to blame, but a core theme should start to appear; identifying that theme can help identify when the bear market might be at an end. Armed with the experience of a bear market, you may find yourself wiser and better-prepared when the next one arrives.

Start Looking at the Macro Data
Some people follow specific pieces of macroeconomic data, such as gross domestic product (GDP) or the recent unemployment figure, but more important are what the numbers can tell us about the current state of affairs. Bear markets are largely driven by negative expectations, so it stands to reason that it won't turn around until expectations are more positive than negative. For most investors - especially the large institutional ones, which control trillions of investment dollars - positive expectations are most driven by the anticipation of strong GDP growth, low inflation and low unemployment. So if these types of economic indicators have been reporting weak for several quarters, a turnaround or a reversal of the trend could have a big effect on perceptions. A more in-depth study of these economic indicators will teach you which ones affect the markets a lot, or which ones may be smaller in scope but apply more to your own investments. (From unemployment to inflation to government policy, learn what macroeconomics measures and how it affects you in Macroeconomic Analysis.)

Position Yourself For the Future

You may find yourself at your most weary and battle-scarred at the tail end of the bear market, when prices have stabilized to the downside and positive signs of growth or reform can be seen throughout the market.

This is the time to shed your fear and start dipping your toes back into the markets, rotating your way back into sectors or industries that you had shied away from. Before jumping back to your old favorite stocks, look closely to see how well they navigated the downturn; make sure their end markets are still strong and that management is proving responsive to market events.

Parting Thoughts

Bear markets are inevitable, but so are their recoveries. If you have to suffer through the misfortune of investing through one, give yourself the gift of learning everything you can about the markets, as well as your own temperament, biases and strengths. It will pay off down the road, because another bear market is always on the horizon. Don't be afraid to chart your own course, despite what the mass media outlets say. Most of them are in the business of telling you how things are today, but investors have time frames of 5, 15 or even 50 years from now, and how they finish the race is much more important than the day-to-day machinations of the market.