Are you prepared for the next bear market?

There's a good chance the headline on this blog entry got your attention; but to be clear, we aren't looking to scare investors and we don't believe the next bear market for equities is imminent. However, as fall and winter have always followed summer, so too must a bear market logically follow a bull market. Unfortunately, unlike the seasons (even amid talk of global warming) equity market cycles can't be gamed using a calendar. Yet the calendar is still an issue because we are about to enter September, which is quantitatively the worst month for stocks, and October, which is arguably the most feared month to own stocks. Given this, you are most likely going to hear increased media talk of pullbacks, corrections and crashes over the next two months. With that in mind and coupled with the fact that this current bull market is almost 5.5 years old (average is 4.05 years) and the S&P 500 just hit its 74th new high on Aug. 25, we do believe equity investors need to begin to prepare themselves for what may come next. We believe through proper preparation — both mentally and physically — an equity investor should be able to insulate himself or herself from the major effects of the next bear market in equities, whether it begins tomorrow or well down the road. But first, some good news. Based on our assessment of the current climate, we believe if the next bear market for equities were to start soon, it should be a lot less harsh than the previous two, which saw losses of 57% (Oct. 9, 2007-March 9, 2009) and 49% (March 24, 2000-Oct. 9, 2002) for the S&P 500. This is due to the lack of a sizable bubble (bubbles were discussed in my last blog entry), like the technology and housing bubbles that were the catalysts for the last two bear markets. Now some bad news. Despite much talk to the contrary, there is no foolproof or proven way to predict the exact beginning and end of a bear market. Some investors and strategists may get lucky and time it right and miss some of the downside, but there is a very good chance they will also miss a good portion of the upside, because when a new bull market begins, it usually begins in a very unannounced, dramatic and robust fashion, and — as they like to say — “miss a little, miss a lot.” As an example, the last bear market ended on March 9, 2009 (based on the S&P 500) and over the next two months the S&P 500 moved up by 37.35% and the S&P 600 (small caps) rose 50.67% (March 9, 2009-May 8,2009). If an investor who was out of the market missed this quick move up but jumped in two months into the bull run, they would have seen a total return of 139.85% for the S&P 500 (May 8,2009-Aug. 21, 2014) versus the whole bull market total return of 230.54% (March 9, 2009-Aug. 21,2014). For the small-cap S&P 600, the total returns are even more disparate at 159.57% and 292.23% respectively. Stated another way, the fact that in the early stages of a bull market run, about 70% of the return comes in 50% of the time. As an example, if the return for a year is 20% during the beginning of a new bull run, we would expect that to be broken down into approximately 14% in the first half and 6% in the second. Clearly the second half is robust, but the best returns came in the beginning and it is very difficult to time that beginning. Given all of this, we believe the best answer for most equity investors is to stay the course through a bear market but, as mentioned above, prepare both mentally and physically. However, let's be clear on what we mean by an equity investor. We would define an equity investor as an individual who understands the inherent risks of the equity markets and has at least a five-year horizon for their investments to play out. If this is the case, Step No. 1 is to prepare mentally for a bear market, which means understanding and coming to grips with the fact that bear markets do exist and that equity bear markets are going to be a “two steps back one step forward” type of event and grind on your nerves daily. On average they only last about 1.2 years (14.5 months) with an average loss of 34% (for the S&P 500). This loss can be potentially tempered by ensuring clients are well diversified across the equity space (diversified across borders, investment styles, market capitalizations and sectors) and by also having exposure to other low correlated assets that have provided some cushion in equity bear markets of the past. These include real estate investment trusts, master limited partnerships, commodities, investment-grade bonds (including U.S. government, corporate and municipal) and cash alternatives, to name a few. In addition, we believe these equity investors should be systematically adding new funds (dollar cost averaging) and/or reinvesting cash flows into the market at reduced levels as this helps remove a big issue of trying to time market bottoms (this strategy clearly applies to bull markets, as well). To sum it up, we believe this equity bull market still has some legs and will keep running on the back of a re-acceleration of corporate earnings and revenues (which has transpired). However, the returns going forward will most likely be a bit more humble than the 24.5% annualized return the S&P 500 has posted so far in this bull market (March 9, 2009-Aug. 21, 2014) or the 23.8% year-over-year total return (Aug. 21, 2013-Aug. 21, 2014). In addition, equity investors need to know there will be setbacks and it's hard to time the beginning, end and severity of those setbacks with any consistent accuracy. We would then recommend to equity investors with a five-year investment horizon that they prepare themselves mentally and physically (through proper allocation and investment strategy) for these inevitable setbacks instead of trying to time the market. Mike Boyle is executive vice president and head of asset management at Advisors Asset Management.