There's no such thing as a risk-free investment. It's important to get this front and center in your mind at the outset.
There are low-risk investments. They are characterized by low volatility and steady, relatively modest, returns. The problem with them is they won't keep pace with your portfolio's greatest enemy — inflation.
To combat inflation, you need, unfortunately, higher-risk investments. They can be quite volatile and the return is uncertain, but such investments do possess the potential to more than preserve your purchasing power.
You probably already know all this, and that is why you have invested — perhaps against your better judgment or emotional preference — a significant portion of your retirement savings in higher-risk kinds of investments.
As we embark on this discussion of bear markets, the unpleasant side of stock-market investing, it's helpful to be reminded that you're in this for a good reason — you're trying to guard your financial security against the long-term ravages of inflation, and stocks are your best bet.
In this article, we'll be discussing an indicator that some readers might wish to use as a signal to reduce their stock market allocation.
While our research indicates that using this indicator would have boosted overall profits slightly if used over the past several bear markets, that's not really its primary objective. Rather, the main value of this indicator is that it can dramatically reduce the intense negative volatility experienced by investors during bear markets.
That's a valuable benefit in and of itself. But this indicator provides a second, related, benefit: by building this indicator into your long-term plan, you're more likely to stick with your plan the rest of the time. Many investors are regularly shaken out of the stock market by short-term stock declines, only to be left flat-footed when the market quickly resumes its upward course. This has a traumatic impact on their long-term returns. Knowing this indicator will help steer you to safety before the worst declines of a bear market arrive can help give you the fortitude to ride out the much more frequent market pullbacks that are a normal part of investing in stocks.
In addition, we recognize there are SMI readers who are approaching a season of life when they need to lower their stock allocation but want to ride the bull market as long as possible before making that change. Others want help deciding when to permanently withdraw funds needed for spending purposes. This indicator is helpful for timing these transactions as well.
Definitions and Characteristics
One of the tricks in any discussion of "bear markets" is defining what we mean by the term. In the financial literature, you'll find that a market decline of at least 10% (but less than 20%) is typically labeled a "correction." It's worth noting that the stock market experiences a decline of this kind, on average, about once every 15 months. Which is to say, we routinely encounter events that seem likely to threaten the economy and stock market. More importantly, most of them don't turn out to be as dire as they seem at first, which is why most corrections are relatively brief.
A "bear market," on the other hand, usually involves a sustained or prolonged market decline of greater than 20%. For example, many market observers would not consider the sharp but relatively short-lived decline that occurred in 1987 to be a bear market even though it easily exceeded the traditional 20% threshold. For our research, we included any drops of 20% or more in the S&P 500, whether they were prolonged or not.
In contrast to market corrections, bear markets usually don't begin with sharp declines, and don't normally begin with an acute sense of fear. The beginning of a bear market is, by definition, the same point as the end of a bull market. Typically the emotional state at the end of a bull market is euphoria, when everyone who can buy stocks has already bought them. There's often a "sky is the limit" sort of feeling, which doesn't go away overnight. Bear markets tend to take their time to develop and, surprisingly, are often characterized early on by investors' absence of fear.
Another tricky aspect of these discussions involves which measure of the market is being used. An index like the S&P 500, which measures large-company stocks, may decline more than 20% while another, like the Russell 2000, which measures small-company stocks, may not. As a result, lists of bear market dates and declines may vary from source to source.
Initially it may seem that the distinction between a market correction and a bear market is merely an academic debate. But this fails to take into account the psychological cost imposed by each. Because every market correction has the potential to grow into a full-fledged bear market, investors can grow fearful when a market decline begins to pile up length and depth. One bad day turns into a bad week, then a bad month, and before long people are wondering if they wouldn't be wise to sell their stock holdings until the market turns back up. That's when costly mistakes, which we hope to help you avoid, are typically made.
When Bear Markets Tend to Suffer their Greatest Losses
While it's unusual for bear markets to begin with a bang, they do often end with one. Bear markets have a tendency to accelerate dramatically as they reach their climax. Emotionally, this is the crescendo of fear that creates a huge final wave of selling, establishing the market bottom and setting the stage for the rebound into the beginning of a new bull market.
Investment manager Ken Fisher has described this tendency as the "two-thirds, one-third" rule. He explains it this way: bear markets have a tendency to experience just one-third of their total decline during the first two-thirds of their lifespan. Then during the last one-third of their duration, they cause two-thirds of their total losses. While that's a bit of an oversimplification of the historical record, it captures the general "late acceleration" idea quite well.
This tendency for the steepest losses to occur late in a bear market tells us we don't need to rush to determine a new bear market has begun. Being patient early helps investors avoid taking counter productive defensive measures, which can result in missing dramatic gains when a feared "bear market" turns out to be nothing more than a short-lived market correction. This is important, as any types of defensive measures taken after a correction or bear market has begun involve considerable risk of selling near a market low, a guaranteed recipe for subpar long-term returns.
Is there a way to combine what we've learned regarding bear markets and corrections into some sort of "early warning system" that would enable investors to sidestep some of the damage a true bear market can inflict? We believe there is, but, as usual, there is an important caveat: This article deals with market generalizations and historical averages. Not all of these points will hold true in every single bear market or correction.
Attempting to create this type of bear market early warning system is a fool's errand of sorts, because the balancing act required is very difficult. On the one hand, you want an indicator that doesn't wait too long after the top before giving its signal. After all, the idea is to help preserve capital. On the other hand, you don't want it to sound too soon, either. If it's overly sensitive, it will give many false alarms, telling you to sell, only to see the market rally to new highs and force you to re-enter at higher prices.
Combining the Pieces: The Bear-Alert Indicator
Combining the elements we've discussed so far forms the basis for our Bear-Alert Indicator (BA). We saw that the "rolling top" tendency of new bear markets allows us to take our time in distinguishing a likely new bear market from a regular correction. We also learned that the "two-thirds, one-third" nature of bear markets often results in a significant portion of a bear market's damage being confined to the last part of its duration. It's reasonable to conclude that risk-averse investors can afford to take their time and get it right in calling a bear market, because the majority of the damage typically happens towards the end anyway. This allows them to stay the course through run-of-the-mill corrections that happen fairly often, yet still take meaningful action when a correction moves closer to bear market territory.
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