The 3 Stages of a Bear Market
Slip-and-falls on steep terrain are far and away the number one killer of high mountain climbers, and interestingly, the vast majority of these falls occur on the descent, the part most would describe as the easy half. It’s easy for a climber to die on the way down, for the whole process lends itself to this outcome, and it’s just as easy for investors to financially perish in a bear (down) market, equally supportive of the tragedy. The S&P 500, the most representative index of the U.S. stock market, stands on the precipice of a bear market today. What is a bear market, and what are its identifying characteristics? What mistakes does it exploit, and how can you avoid making one?
A bear market is most generally defined as a 20% decline from the recent high mark. Year to date, the NASDAQ is down 30%, the S&P500 is down 19%, and the Dow Jones is down 15%; the strong indication is we are in the beginning of a major bear market.
As described in Bob Farrell’s 10 Rules of Investing, the three stages of the bear market are as follows:
Sharp down
Reflexive Rebound
Drawn-out fundamental downtrend
The ‘sharp down’ stage has clearly already occurred, and given the S&P 500’s 11% recovery, and the Nasdaq’s 16% recovery, from March 14 to March 29,² maybe the ‘reflexive rebound’ stage has as well. This means several things about the stock market today: investors are still too optimistic about stocks in the short-term, the worst is likely yet to come, and a ‘drawn-out fundamental downtrend’ likely lies ahead.
Whether this is ‘officially’ a bear market remains to be seen, but if it is, the following mistakes will likely prove deadly for investors:
Buying aggressively into the peak (late last year, at price levels that may not be seen again for a decade or more).
Allocating the overall portfolio too aggressively at a major market peak (again, late last year; returns are most attributable to portfolio allocation, not security selection. Fidelity went public in the last year saying its customers were far too risky for their own well-being).
Overconcentration (too much exposure to a small number of holdings; too little real diversification; too much correlation among holdings).
Capitulating at the bottom of the bear market (selling indiscriminately at the market bottom to stop the pain).
Easy to comprehend, hard to practice methods of avoiding the aforementioned mistakes include:
Buy great businesses whenever they trade at a reasonable price.
Know yourself as an investor, be well acquainted with your tolerance for volatility, and appropriate your investment capital in a manner consistent with these two things.
Diversify holdings to mitigate a large loss scenario.
Understand the investing environment, and the types of investments and industries that thrive in that environment. Investors generally associate deflation with a bear market, yet those who do so this time will be sifted by rapidly rising prices.
Stick to your bear market plan, and regarding high quality holdings, slay your emotions to avoid selling them at depressed prices.
Build cash, wait for broad capitulation, and pray for wisdom and courage to buy great stocks when others are fearful.
Think about it, Shaun.
“It’s better to buy a great company at a fair price than a fair company at a great price” ~Warren Buffet
1,2 Yahoo Finance, May 20, 2022 https://finance.yahoo.com/
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial. The economic forecasts set forth in this commentary may not develop as predicted.
All investing involves risk including the possible loss of principle. No strategy insures success or protects against loss.
Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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