10 Lessons From a Bear Market

It’s tempting to study and learn more about bull markets – the how’s and why’s of booming investment success. The investor’s goal of course is to implement what he learns into his own portfolio. Until recently, however, far less attention has been paid to bear markets. The recession has inspired more people to look for the lessons behind the wreckage, perhaps to better fortify themselves against future downturns. So today, we will turn our attention to 10 lessons any consumer or investor can absorb from the current and maddeningly long bear market.

Take the Predictions of Journalists With a Grain of Salt

By this point, most everyone has seen the confrontation between Daily Show host Jon Stewart and disgraced Mad Money host Jim Cramer. For those who have not, suffice it to say that Stewart took Cramer to task for brazenly encouraging viewers to keep sinking their 401ks and savings into questionable Wall Street investments in the years prior to the recession. Cramer is hardly the only guru at fault, though. While it’s hard to top the insanity of telling us to leave our money in Bear Stearns as late as March 2008, plenty of other TV personalities have been shown to be less than prophetic about the financial future. Ask yourself whether the media (whose quest for ratings often contradicts your quest for sound returns) is best suited to shape your investment decisions before assuming their advice is infallibly correct.

What Goes up Must Come Down

Business and the stock market are cyclical. They always have been and likely always will be. Unfortunately, there is an all-too-human tendency to read permanency into events, such as concluding that a booming market will continue to boom and perhaps boom even more. This attitude played a large role in the subprime mess, as Harvard MBA John T. Reed discusses in his penetrating article on the financial meltdown:

“They [subprime borrowers] were speculating that homes would continue to go up in value and they would get rich from the appreciation as a result—all before the foreclosure happened.”

Reed demonstrates many sub-prime borrowers knew full well that they could not afford their homes under normal market conditions, but nevertheless “gambled” that housing prices would keep rising and let them cash out before anyone was the wiser. Even in perfectly honest cases, it is easy for investors to assume a certain stock (or the whole market) will keep going up, and keep plowing money in. Don’t fall victim to this mindset. Speculate if you must, but realize that what goes up must always come down.

Separate “Play Money” From Core Investments

Another sensible bit of advice involves separating “play money” – money you speculatively invest into stocks you hope will pan out – from core investments such as those expected to fund your retirement or kid’s college education. There is nothing wrong with speculative investing as such. Many investors fondly recall stories of stock market gambles that paid off. The problem occurs when speculation (those which many sub-prime borrowers engaged in) overlaps with serious life goals like home ownership, and thus leave them stranded when their gamble turns out to be a bust. By limiting such investing to only discretionary money, you will be insulating yourself somewhat from the fallout of bear markets.

Inspect Your Investments Before Automating Them

Today’s investors live in the age of automation – index funds, mutual funds, and other investment vehicles that operate more or less on autopilot from the start. This is fine as far as it goes, but every investor needs to do some inspecting before pushing the automate button. A Dallas News story reports on various index and mutual funds that were “down 50 percent to 60 percent before the bear released his grip.” While the individual investor is powerless to prevent entire market downturns, they can at least ensure that their own investments form an appropriate match for the market they are investing in. The same Dallas News piece advises, “…nimble small- to mid-cap funds, which generally lead a recovery” for investors in today’s – and presumably any – recession.

An Old, Conservative Investment Fund is Not Immune to Losses

Wall Street is desperate to spread the notion that investors cannot go wrong if they invest in old, conservative, broad-based index or mutual funds. “You come out alright unless the entire market tanks” is the typical defense of these investment vehicles. But sometimes the entire market does crash, as it has been doing since late 2008. When this happens, index funds and mutual funds that are pegged to the performance of an entire stock market can and do suffer losses – sometimes substantial losses. If you have a long time horizon – that is, if you are young – you can afford to sit tight while your holdings in these funds rebound. But if not, simply being invested in an index fund does not immunize you from stock market losses. They are just as real as if you had recklessly dumped every penny you own into one losing stock.

It’s Not Over ‘Till it’s Over

Recessions happen for a reason. One explanation, as discussed earlier, is the cyclical nature of stock markets. This recession was arguably caused by too much borrowing, too much credit and not enough discretion regarding who was being lent money. High unemployment and lagging stock prices are symptoms of that, not the cause itself. It took years (and in some cases decades) of wrong decisions mounting up to produce the painful problems we are now experiencing. For this reason, it makes little sense to expect rapid recovery – either in making our own investment decisions, or in evaluating the promises of political leaders or journalists. As the old saying goes, it’s not over ’till it’s over. No one can “stimulate” the economy in any enduring sense without the underlying problems being resolved.

It’s About Earnings, Not The Stock Price

Most people lack the time or inclination to do a lot of research into companies they invest in. This is what makes index funds and mutual funds a good idea for these people. Warren Buffet takes a different approach, as a Motley Fool article discusses. Rather than focusing on the quick, easy read on company performance – the stock price – Buffet focuses on the business itself and its earnings.

“That’s why he didn’t sell Coca-Cola (NYSE: KO) even though the share price flat-lined for more than two years in the early 1990s, just a few years after he bought it in 1988. But while the stock stalled, net income and free cash flow continued to climb. Only belatedly did the market realize what the business was doing, and the stock soared some 300% before sputtering again in 1998. Just staying with that business has led to a 600% gain overall for him, even including the recent fall.”

Many companies with perfectly healthy cash flow and profits saw their stock prices fall last year based on little more than fear and paranoia. Buffet’s advice to bear market investors is to ignore these emotions in favor of cold data on the company’s true viability.

A Bad Overall Economy Does Not Mean All Investments Are Losers

Politicians and journalists tend to discuss recessions in broad, sweeping, general terms. The notion most people come away from these sources with is that bear markets mean the whole economy is in shambles. The correct approach is to think more about the specific circumstances facing specific companies or industries. Motley Fool offers the following as an example:

“..if you’re interested in a miner, look to see that it can extract the metal out of the ground more cheaply than its competitors by controlling costs, is not unduly leveraged, and can make a profit over a reasonable range of metal prices.”

Assuming these criteria are met, it is unlikely that “the economy being bad” will doom this investment to failure. Always remember that “the economy” or “the market” is nothing more than individuals and institutions interacting with one another. It is not not an independent mechanism of its own.

Invest According to Your Time Horizon

In light of the constant negativity discussed above, it is tempting to unload poorly performing investments regardless of your own situation. However, this is not always best. The advice to “cut your losses” might apply to a sixty year old man with five or six years remaining until he needs to liquidate his investments to retire. But is it appropriate for a 25 year old who has at least forty years of investing time left? In this case, it might be best to simply let your index fund or mutual fund rebound, as history suggests it will given such a long time frame. The point is to be mindful of your time horizon when making investment decisions in a bear market, rather than cutting your losses in knee-jerk fashion.

Bad News Comes in Bunches

The market is rarely caught completely by surprise. Behind every collapse, one usually finds a trickle of of bad news, followed by still worse news until the trickle became the tsunami that plunged on the Dow Jones. This is true even within specific companies, some of whom are so big as to trigger a market-wide downturn when they fail. The Times UK illustrates this principle in its timeline charting the fall of Bear Stearns. Following the timeline reveals bad news emanating from the company going back as far as mid-2007, in the form of diminishing profits and questionable loans to bail out hedge funds hit by the housing bust. Indeed, some investors apparently did forsee trouble at Bear Stearns, but were not in the majority. The point is that bad news often foreshadows bad things still to come, so be careful.