What to do in a Bear Market

Financial Markets are going through a period of significant volatility which is adversely impacting on investment portfolio valuations - we have seen and experienced this before.


In times like these, it is critical more than ever to maintain the integrity of our investment portfolios. Sitting through a downturn is difficult but, as I’m sure you will appreciate, that value is not lost just because the price has changed. Often the hardest part of investing is doing nothing because it seems so counterintuitive.


Our advice is to be disciplined, remain invested and stick to your long-term investment strategy, avoiding the fatal error of believing in the ability to time the market.


We thought it important to share our thoughts.

There are many factors that drive short term market returns and the raising of US interest rates at the start of 2022, aimed at curbing rising inflation, was a strong determining factor in the fate of markets for the year to date. However, while this downturn has been difficult to deal with, one needs to bear in mind that this is not the first time we have dealt with a market downturn this century. Our memories are short, so it helps to remind ourselves of what has happened in the past.


The US market specifically has lost 30% or more on 3 separate occasions in the last 22 years, with the most recent being in February 2020. Yet in the long run it continues to show positive growth. The chart below illustrates how these negative events have been absorbed over time to ultimately deliver an acceptable return. Even going back as far as the darker days of the late 80s this holds true.



The astute investor might at this point be asking whether equities have fallen sufficiently to start offering up bargain buys, but market forecasting is a thankless task and it is nearly impossible to get it right on a consistent basis, for the simple reason that no two bear markets are the same. Often, just as a signal that foreshadowed the previous downturn reappears, the stock market surges and those who have retreated to cash are left ruing their error.


Speaking generally, we can assess value and from there assess potential outcomes based on reasonable market assumptions. The charts below illustrate the degree of “cheapness” on a relative basis using a P/E multiple over time, while also indicating where the market is currently trading relative to the long term average. Across the board this would suggest that equities are a good long term buy, even if volatility remains in the near term.


Another method to use is the Shiller CAPE ratio. It too computes the market’s price/earnings ratio but using an average of the past 10 years’ corporate earnings (adjusted for inflation), rather than 12-month results. Doing so reduces cyclical effects, so that P/E ratios are not inevitably high during economic slumps and low at peaks,


Todays ratio is certainly not suggestive of a screaming buy but it definitely doesn’t suggest its worth selling at this point either. The bright side is that current valuations in the US are close to the 30-year norm, and stocks have typically delivered exceptional results over the ensuing three decades from these levels. Valuations in other regions suggest even more appealing entry points.


If we are to venture into the dangerous game of market forecasting, one also has to factor in interest rates, the relative opportunities now present in the bond market and economic expectations for the coming year. Should the economic news worsen, the Federal Reserve continue to raise interest rates early into next year, or corporate earnings head firmly south, then equities are likely to continue a downward trend. However, if the economy avoids those problems then stocks are likely to rally. As the 30-year averages show, equities can profit handsomely at these levels - assuming the economy plays its part.


So, what to do?

The answer to that question is specific to each individual’s circumstances. However, assuming ones equity exposure is in keeping with an acceptable level and that a forced sale to meet income is not necessary, it is critical to remaining invested during periods of volatility. Conversely, believing in the ability to market time is a fatal error. The market is not a perfect pricing mechanism for assessing value - it is simply the general consensus of those willing to assume risk, while taking current market unknowns into account.


The graph below illustrates the danger of trying to time the market. The financial crisis of 2008 may have been the one occasion when a flight to safety was justified, considering the sovereign risk we were seeing for the first time.


The father of value investing, Benjamin Graham, explained the market by saying that in the short run it is like a voting machine - tallying up which firms are popular and unpopular. But in the long run the market is like a weighing machine - assessing the substance of a company. The message is clear: what matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion on short-term prospects.


Over the long term, when companies perform well, their shares will do so too.


Provided your portfolio is structured in line with your long term objectives, it is imperative to remain disciplined in difficult times. It can seem counterintuitive to do nothing when we are suffering but this is an important principle, applied by many successful investors over time.


Regards

The Baymont Wealth Team