Under the article title, This is the chart that stock bulls don’t want you to see, Mark Hulbert relays the "frightening conclusion" of a new study reporting that "At some point in the next five years, the U.S. stock market is likely to be more than 30% lower than where it stands today." On the surface, yes, that does seem like a "frightening conclusion." But is it really surprising?
We've had a 5-year bull market already. Going another five years without a significant bear market along the way seems unlikely. As much as we'd like the next bear market to be meek and mild, that idea also seems unlikely, given the amount of stimulus and the propping up of the asset markets by the Fed over the past five years. More importantly, though, what does this analysis really mean? Here's Hulbert's assessment:
To be sure, this recent study is not the first to point out the bearish implications of the above-average CAPE level in the U.S. But what is unique is that it focuses not on overall returns but on drawdowns. That’s important because long-term averages mask how volatile the market may be along the way, which, in turn, is related to how likely it is that we’ll bail out of stocks at some point in the next few years. The bailout point is usually at the point of maximum loss. Imagine, for example, that the stock market will provide an inflation-adjusted return of 1% to 2% annualized over the next decade. That’s consistent with some analyses of what today’s high CAPE reading means. While that return is mediocre, it may still be high enough to convince you that it’s worth remaining invested in stocks, especially given the bleak outlook for long-term bonds. But what if, on the way to producing that modest longer-term return, the market at some point plunges 35%? Many investors would find that loss intolerable and, therefore, bail out of stocks — which means they would not participate in any subsequent recovery that produces the net longer-term return of 1% to 2% annualized.
It's important to note that this study, despite the prediction of a significant bear market within the next five years, still expects U.S. stock returns to be 1.4% above inflation annualized over the next five years. Not very exciting, but still progress. And if you skim the actual study, you'll see that the main point is actually that there are many other foreign markets that look more attractive and seem less exposed to the likelihood of significant drawdowns from present levels. That dovetails nicely with our September cover article: Why Your Portfolio Needs Foreign Stocks.
SMI has long counseled that you shouldn't have money invested in stocks that you can't afford to leave there for at least five years, and preferably ten years. That is precisely due to the drawdown risk highlighted by this study. Not only would it not be a surprise if there's a significant bear market sometime in the next five years, it would be surprising if there isn't one. That doesn't mean the wise investor should run for the exits at this point. But it does mean that a wise investor will evaluate whether their investing plan is sufficient to keep them from making costly decisions in the midst of the next bear market.
Austin wrote yesterday about the questionable prospects of indexing during the next bear market. Index funds are getting a lot of press right now because their returns look so favorable compared to active strategies over the past five years. But index funds have no brakes, so if my sole investing approach was indexing, I would be considerably more concerned about the prospect of an oncoming bear market. The fact that Upgrading has shown some ability to mitigate damage during bear markets, and more importantly, the fact that DAA's back-tested performance through past bear markets has been so impressive, gives me confidence facing a future that involves not just the chance but the likelihood of a future bear market.
Personally, I expect the damage of the next bear market to be significantly muted by my portfolio's allocation to DAA. My investing time frame is (significantly) longer than the next five years and I'm not concerned that I'm going to bail out even if stocks take a fairly dramatic turn lower. All of which gives me the confidence I need to stay invested today. Many investors who have lacked that confidence have exited (if they ever got back in after 2008) a year or two or three ago, and have missed huge gains as a result. Bear markets follow bull markets which follow bear markets and on and on. There's no more basic lesson from stock market history than that. The key is making sure your plan will prevent you from becoming investor roadkill when the next bear market roars along.