Broker Check

Can You Learn to Love the Bear?

December 20, 2018

As we approach the end of the tumultuous 2018, bears are in control.

Volatility has increased, large sell-offs seem to have become the norm, and there is frequent talk of an economic slowdown or recession. Adding fuel to the bearishness is the fact that the traditionally bullish month of December is currently on track for its worst performance in years.

Investors are conditioned to fear and hate bear markets and with good reason. All of us dedicate an enormous portion of our lives to gain financial security. Few things in life can produce as much anxiety as a bear market threatening to take it away.

Having said this, we do believe that much of the fear of recessions and bear markets is irrational and stems from not understanding their cyclical nature or how to effectively protect oneself.

Bear Markets Are Inevitable…

Just like night follows day, recessions and bear markets inevitably follow economic expansions and bull markets. They are impossible to prevent despite the efforts of politicians and central bankers.

Throughout the course of an economic expansion asset prices increase until valuations reach irrational levels. Most of the available capital becomes invested and many investors resort to dangerous behavior including taking on debt to chase steadily diminishing profits. Ultimately, this situation becomes unsustainable and it ends.

Unlike natural cycles, however, economic and market cycles are irregular: they can vary greatly in length and severity. They are also hard to measure and predict.

Several economic indicators (e.g. an inverted yield curve) are currently signaling that a recession is very likely in the future, but there is no way to pinpoint when this will happen and how long or severe it will be.

Some economic measures also work with a significant lag. For example, onset of a recession can only be determined months after its actual start. The Business Cycle Dating Committee’s (we are not kidding, there is such a group) determination of the peak date of the last economic expansion in December of 2007 occurred 11 (“eleven!”) months after that date.

Therefore, it is possible that we are already in a recession but will not know it until well into next year.

Further complication is that, as the saying goes, the stock market is not the economy. Financial markets react more to short-term events and sentiment than the economy. As a result, markets are more volatile and corrections and bear markets are more frequent than economic recessions.

This irregular and sometimes irrational behavior of economic and market cycles naturally increases investor uncertainty, anxiety, and fear.

…And So Are Bull Markets

Every night, regardless of how long, dark, or cold, leads to a new day and it has been the same with economic and market cycles for as long as anyone can remember.

Recessions and bear markets also eventually run their course, become unsustainable, and end. Bad investments are liquidated, reckless investors are forced to take their losses, there is a surplus of liquidity and capital while asset valuations reach absurdly low levels.

Like the mythical Phoenix, new bull markets can only be born from the ashes of previous economic cycles.

This is a critical, yet often misunderstood aspect/benefit or bear markets: they lead to significant investment opportunities as they allow calm and astute investors to buy high-quality assets that will produce extraordinary long-term profits. Thus begins a new bull market.

The challenge for most investors is purely emotional: it is incredibly difficult to peruse the ash heap of investments during the depths of a bear market when everything is overwhelmingly negative and everyone is gripped with fear.

Can You Love the Bear?

The short answer for nearly everyone will always be no.

Bear markets will always remain unsettling yet unavoidable. Regardless of how you feel about them you must be prepared.

Even if they always eventually pass, bear markets can cause substantial and in extreme cases catastrophic damage. This is especially true for investors who find themselves too aggressive and/or leveraged at the end of a bull market.

If there is a full-blown bear market in 2019, you will again see news about investors who went spectacularly broke. As Warren Buffett famously said:

“You only find out who is swimming naked when the tide goes out.”

In our opinion, preparing for a bear market should always start with having a plan that ensures your investing strategy is consistent with your ability to stomach temporary portfolio declines.

Doing this will allow you to best weather the market fluctuations and the feeling of discomfort that is very common for every investor in a bear market.

Most importantly, having an investing strategy tailored to you will do a much better job preventing you from making investing decisions based on fear as these most often lead to long-term financial harm.

To paraphrase another wise man, the best investing strategy is not necessarily the one that maximizes gains, but the one that allows you to sleep well during bear markets.