Bear Markets Can Steal 50% Of Your Gains

Retail investors and the financial press only recently started to worry about bear markets after stocks have already experienced a substantial decline. In January 2018, the news headlines got so ridiculous some claimed stocks could never fall. The retail money follows the sentiment, going all in when stocks near their peak and selling near the bottom. You want to avoid this recipe for underperformance by always staying grounded in your analysis and allocations. That does NOT mean you should always fade retail investors and the media. They will only be wrong at extreme moments. The problem for retail investors is they can be right most of the time, but still underperform because of poor timing at inflection points.

It’s best to remind yourself how devastating a bear market can be while you’re still in a bull market so that you have an appropriate perspective in order to make rational decisions rather than emotionally based ones. This doesn’t suggest that you should withdraw money entirely out of risk assets, but an adjustment to portfolio allocation is necessary when markets are overvalued, which increases the probability of negative catalysts pushing valuation lower.

Over the long term, even if stocks do well in nominal terms, you don’t need to time sell offs perfectly to avoid the risk associated with them. Even becoming conservative in your risk allocations a couple years before a top can be advantageous. There’s no need to try to be a hero and call an absolute top. It’s much more realistic to scale into and out of risk assets. It’s unrealistic to expect this current bull market to fall back to the March 2009 lows as some of the most ardent bearish investors propose. However, historical context dating back to 1933 suggests that on average a bear market repossess more than 50% of the bull market gains in stocks, especially since today the S&P 500 has a high Shiller PE.

Inflation-Adjusted Returns Examined

Most bullish investors are plagued by recency bias, perpetuating the belief that the future looks like the immediate past and stocks will continue moving higher. However, the key to understanding future returns is to judge the stocks based on risk, adjusted for inflation. You can look at returns adjusted for volatility, but the risk isn’t just based on the past movement of stocks. When stocks are expensive they present more risk than when they are cheap. Even if stocks had a great risk-adjusted return in 2017 based on volatility, returns weren’t as amazing as they appear at face value. If you think stocks are expensive based on a multitude of valuation measures, they present high risk while they are increasing.

Stocks actually don’t always move up in real terms. If an investment only goes up because the value of the currency falls, it’s not returning anything. As you can see from the chart below, there have been many decades where the S&P 500’s real returns were flat.

Source: Twitter

The worst period was from 1929 to 1985. That’s a 56-year span where stocks had no real returns. This isn’t an argument to sell stocks and go into cash. It is a refutation of the narrative that stocks are always a good investment. The current market is an example of the good times. It’s possible to reap the rewards of a bull market with momentum while acknowledging future real returns can be slim.

Fed Is No Longer Supporting Stocks

When the Fed was doing its Quantitative Easing Program and had zero percent interest rates, the mantra was to not fight the Fed. Now that the Fed is raising rates and unwinding its balance sheet, those same investors are still bullish. It makes sense to go long stocks when the Fed starts to raise rates, but towards the end of the hike cycle, it makes sense to be bearish. It’s easy to see that recessions occur after the Fed stops hiking rates. The problem is it’s not easy to see when that will occur because the Fed will have guidance to hike rates even though the economy is about to fall into a recession. Therefore, you need to anticipate the end of the Fed’s hike cycle in advance. As you can see from the chart below, hike cycles usually lead to stressed financial conditions.

Source: UPFINA

You want to have a conservative portfolio before financial conditions become stressed. One asset which is often disregarded by mainstream investors until it’s too late is gold, which is a historically strong portfolio diversifier as we reviewed in Is Gold A Good Investment. With the Fed hiking above the core PCE and unwinding QE at a quicker pace in 2018, the end of the hike cycle is closer than ever. With that in mind, its important to remember that bear markets can easily steal half of the gains of the preceding bull market. When you’re deciding to take risk in stocks notice how high valuations increase the risk of your portfolio. Also, stocks can have zero real returns over many decades, so it’s not always a good time to buy, and there is always an alternative. Based on history, it’s poor timing to increase portfolio risk when the Fed is finished hiking rates and it exceedingly appears that this event is closer than ever.

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