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A Secular Bear? Thinking about Investment Strategies

A bear market is commonly defined as one in which the stock market, as measured by a benchmark index such as the Standard and Poor’s 500 or the Dow Jones Industrial Average, has declined 20% or more from its most recent peak. We are now in a bear market and have been for some time. The S&P and Dow are now down over 30% (around 40% for the latter) from the last peak.

At this point, we’re at about the average decline for the last 10 bears (just over 30%). Which is not to say things couldn’t get worse, of course. The post 1929 crash bear market saw stocks decline by 90%. The 1973-74 bear market and the bursting of tech bubble both took the indexes down by around 50%.

The big question, it seems to me, however, is whether we’ve entered a secular bear market. An article in the WSJ today claims that we are:

“We are in a secular bear market,” says Russ Koesterich, head of investment strategy at Barclays Global Investors in San Francisco, using Wall Street jargon for this kind of prolonged weak period. Analysts distinguish between long-running “secular” periods and shorter-term bear markets, such as the one that occurred from 2000 through 2002.

“We had a secular bear market from 1968 to 1982, and another that began in 1929,” Mr. Koesterich says. Stocks sometimes mount strong rallies during the lengthy weak periods. They nearly doubled in value from 2002 through 2007, but have since given back most of those gains.

Let’s me more precise, however. A good working definition of a secular bear market is “a series of two, three or more individual “cyclical” bear markets (with cyclical [bull markets] in-between), where in general, each successive bear market achieves a lower level of valuation at its trough.” In the following chart, notice how well the 1966-1982 period matched that definition. There were three consecutive bear markets, each of which bottomed out lower than the previous one, followed by a fourth in which the bottom was finally higher than the prior one:

I don’t believe in charting or technical analysis, so I don’t want to put too much stock in these sort of graphs (pardon the pun), but I think it’s worth noting the very real prospect that the current cyclical bear market could bottom out at a level substantially below that of the 2000-2002 bear market. Consider, for example, that P/E ratios failed to fal back all the way to historical norms during the 2000-2002 bear market. Consider also that the current economic crisis is far more broadly based that the bursting of the tech bubble. Even before the credit crunch, serious economists were starting to talk about things like stagflation that haven’t played the economy in decades. So I think the odds are pretty high that we are in the middle of a second cyclical bear market of a protracted secular bear market. If so, there’s probably at least one bull rally and one more deep bear market ahead of us, the net effect of which will be to leave the stock market even further down than it is today.

If we are in a secular bear market, there are some key investment strategies that you need to consider. First, it will be tempting to try to time the market so that you’re in stocks at the peaks and in bonds at the trough. Or you could try being in high beta stocks on the way up and low-beta stocks on the way down. Or whatever. Don’t succumb to that temptation. Nobody’s good enough to consistently time the market. When you factor in transaction costs, moreover, trying to time the market can often result in below-market returns. You want evidence? Pick up the latest edition of Burton Malkiel’s Random Walk Down Wall Street, in which he recounts the data in a way highly accessible to the typical investor.

Second, do diversify. Diversify both across and within asset classifications. Various investment classes are not necessarily correlated. To take a common example, gold will foten do well during periods in which stocks are doing poorly. At the very least, hold stocks, bonds, and cash.

Within those classes, diversify. Diversification eliminates your exposure to firm-specific risk. If you had one-third of your assets tied up in the stock of Wachovia, for example, you’re now in very big trouble.

Third, do not try to actively manage your portfolio. Yes, Peter Lynch famously actively managed Magellan for years. Yes, Warren Buffet has beaten the market for years with active management. You are not Peter Lynch. You are not Warren Buffet. The evidence is clear that most investors--including most mutual and pension fund managers--do not systematically beat the market over time. Again, Malkiel has the data.

Taken together, the first and second points suggest that no load, low expense ration, passively managed, index funds are where your stock and bond investments should be made. You get diversification and assurance that, at worst, your portfolio will match the market returns (which is the best you can hope to do).

Fourth, do consider active asset allocation. Figure out an allocation of your portfolio between stocks, bonds, cash, and other assets that you find comfortable. The odds are that your first cut will be too risk averse, so go back and do it again. Malkiel has some recommended asset allocations, as does the Alexander text. There is a great article on diversificaton and asset allocation available free from the Wharton Knowledge Base. As I approach age 50, I’ve been tweaking my investment portfolio towards a 70-30 equity to fixed income (bonds and cash) ratio. Within the equity class, I’m at about one-third each large cap, small cap, and international stocks. Within the fixed income category, I’m about 50-50 municipals and corporate and about 70-30 long versus short maturity. Over time, as my various investments perform, it’s likely that the percentages will changes as some sub-categories out perform others. At this point, I have two options:

1. Dynamic asset allocation: Sell assets in categories that are declining in value. Buy assets that are rising. This approach accelerates the rate at which your portfolio will become unbalanced from your chosen asset allocation.


2. Strategic or constant-weight allocation: Here you want to maintain the initial asset allocations over time. Accordingly, you periodically sell assets that are rising in value and buy those that are declining.

I prefer the latter. Dynamic asset allocation smacks of market timing, albeit timing of sectors rather than individual assets. More important, presumably I set my asset allocation to reflect a long-term degree of risk that was appropriate for my circumstances. Dynamic asset allocation can cause my actual portfolio to skew rapidly away from my targets, raising (or lowering) my risk exposure from my ideal. Put another way, dynamic asset allocation tends to skew the portfolio towards assets that are correlated with one another (i.e., assets that have the same reaction to systematic risk and therefore tend to move in parallel). This defeats the whole purpose of diversification across asset classes, which is to create a portfolio consisting of assets that are not correlated. Greater correlation = greater variance = greater risk.

OTOH, I understand the argument many people make that strategic asset allocation amounts to punishing your best performers and rewarding your worst performers. It’s the price you pay, however, for being risk averse.

While YOU probably should not try to dynamically allocate your entire portfolio, you may want to include some mutual or pension funds in your portfolio that do use dynamic asset allocation. The funds are making use of market timing computer programs that some people believe are capable of making reasonably good predictions about changes in market trends.

At the very least, go buy Malkiel’s book. Right now.