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 indices 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 combined legislative and regulatory changes in the marketplace. Cyclical stock-return patterns 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 long-term stockholders' returns. If investors 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 Buffett or Peter Lynch. While that kind of perfection is simply beyond reach, savvy investors can see far enough around the corner to adjust 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

Growth Stocks: 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 and earnings growth higher than market averages) falling in price. Value stocks: These stocks may outperform the broad market indices because of their lower P/E ratios and perceived earnings stability. Value stocks also often come with dividends, and this income becomes more precious in a downturn when equity growth disappears. Although value stocks tend to get ignored during bull market runs, there is often an influx of investor capital and general interest in these stodgy companies when markets turn sour. Lesser-Known Stocks: 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. Defensive Stocks: 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. Options: Another way to help cushion your portfolio losses is to use options contracts. If you feel that a bear market is around the corner, then selling calls or buying puts may be a wise course of action if you are familiar with how options work. If you feel that the bear market is nearing an end and economic indicators are signaling a possible rise in the near future, then it may be time to buy calls or sell puts. A correctly called purchase of puts or calls at the right time can substantially cushion the blow of a bear market, as can the additional income generated from selling them. Selling Short: Shorting stock can be another good way to profit in a bear market. This practice consists of borrowing stock that you don't own now, selling it while the price is high and then buying it back after the price declines. You can also do this with stock that you already own, which is known as shorting "against the box." Of course, as with option trading, there are risks involved; if the stock price continues to rise after you have sold short, you will lose money. But this can be another effective method of generating income in a down market if your timing is right. Harvest Tax Losses

Investors who hold securities that have depreciated substantially from their purchase price may find a silver lining in some cases. If you sell your losers while they are down and wait 31 days before buying them back, you can realize a capital loss that you can report on your tax return for that year while maintaining your portfolio allocation. You can then write these losses off against any capital gains that you realized for that year up to the full amount of the losses. For example, if you have a single stock that did well and received a $10,000 gain, and then you were able to realize $5,000 in losses, you could net that loss against the gain and only report a $5,000 gain for the year. But if those numbers were reversed and you had a $5,000 net loss for the year, IRS regulations only allow you to declare up to $3,000 of losses on your return against other types of income. So you would report that amount for that year and the remaining $2,000 the following year.

Harvesting tax losses may provide another opportunity for you to improve your portfolio if you sold individual securities for a loss and are waiting for the necessary 31-day window to elapse before you dive back in (if you buy back the same security sooner than this, the IRS will disallow the loss under the wash-sale rules). But you might be wise to buy an ETF that invests in the same sector as the holding you liquidated instead of just buying back that same security. You would not have to wait 31 days to do this, since you are not buying back an identical security and you would also further diversify your portfolio.

A Case Study: 2008 Bear Market

Consider the bear market that occurred at the beginning of 2008. The investment banks were making ridiculous money from selling collateralized debt obligations (CDOs), which were ultimately backed by consumer mortgage debt and then credit default swaps, which were speculative insurance instruments that would pay out if borrowers in the CDOs they insured w! ere to default. Of course, Wall Street's insatiable appetite for the income from CDOs caused issuers to begin inserting subprime mortgages into them, and mortgage lenders were now free to irresponsibly market mortgages to buyers who had no business owning homes. Adjustable-rate loans were the final straw that broke the camel's back. Once borrowers started to default on these, the whole system collapsed. The U.S. government had to step in and bail out AIG, the ultimate insurer of the credit default swaps, which owed enormous sums of money to those who had paid the premiums on them.

Of course, by this time CDOs had found their way into numerous institutional portfolios, pension funds and investment banks. Bear Stearns was the first financial stock to plummet, and most other major financial conglomerates soon followed, including Bank of America, AIG and Lehman Brothers, which went bankrupt and was not bailed out by Uncle Sam.

Those who had studied the economic signals could see the coming crisis when the real estate market peaked in 2007 and the number of defaults started to rise. Those who paid the premiums on credit default swaps made vast fortunes, while all holders of these instruments and CDOs suffered horrendous losses. But investors who shorted financial stocks in 2007 or bought puts on the market indices profited enormously.

The Snowball Effect

As always happens near the peak of a bubble, confidence turned to hubris and stock valuations grew well above historical norms. Some analysts even felt the internet was enough of a paradigm shift that traditional methods of valuing stocks could be thrown out altogether. But this was certainly not the case, and the first evidence came from the companies that had been some of the darlings of the stock race upward – the large suppliers of internet trafficking equipment, such as fiber-optic cabling, routers and server hardware. After rising meteorically, sales began to fall sharply by 2000, and this sales drought was then felt by those companies' suppliers, and so on across the supply chain.

Soon the corporate customers realized they had all the technology equipment they needed, and the big orders stopped coming in. A massive glut of production capacity and inventory had been created, so prices dropped hard and fast. In the end, many companies that were worth billions as little as three years earlier went belly-up, never having earned more than a few million dollars in revenue.

The only thing that allowed the market to recover from bear territory was when all that excess capacity and supply got either written off the books, or eaten up by true demand growth. This finally showed up in the growth of net earnings for the core technology suppliers in late 2002, right around when the broad market indices finally resumed their historical upward trend.

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 is what the numbers can tell us about the current state of affairs. A bear market is 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 great deal, and which ones may be smaller in scope but apply more to your own investments.

Parting Thoughts

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.

It may take some time for a consensus to form, but eventually there will be evidence of what caused the bear market to occur. Rarely is one specific event to blame, but a core theme should start to appear, and 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.

Bear markets are inevitable, but so are their recoveries. If you have to suffer throu! gh the mi! sfortune 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 five, 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.