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Driving towards a stormy sunset

Bloomsbury blog How to prepare for a Bear Market

Bloomsbury newsletter, 31 March 2015

We concluded long ago that markets cannot be accurately timed or forecasted.

That conclusion comes partially from experience, and partially from looking at a tremendous amount of empirical evidence. In an Oxford University study called A Comprehensive Look at the Empirical Performance of Equity Premium Prediction (academic speak for 'can markets be timed?'), the authors looked at 22 common market timing models. Here's their conclusion:

Our article comprehensively re-examines the performance of variables that have been suggested by the academic literature to be good predictors of the equity premium. We find that by and large, these models have predicted poorly both in-sample and out-of-sample for 30 years now; these models seem unstable, as diagnosed by their out-of-sample predictions and other statistics; and these models would not have helped an investor with access only to available information to profitably time the market.
(emphasis added)

The world's greatest investor, Warren Buffett, summarised it better - "I have never met a man who could forecast the market."

We are currently in the middle of what has been a very good market for investing. Over the last three years ending February 2015, the NZX 50 is up 20.95% per year. The annual returns for the NZX 50 over the last six years ending February 2015 have been 25.13%, 6.79%, -1.42%, 30.02%, 15.51% and 17.80%.

What no one knows is whether this is the middle of an Australian style 16 year bull market run, or not.

However, what we do know for certain is that negative markets will return eventually, and the best thing we can do as investors is to prepare ourselves emotionally now - while markets are positive - to behave appropriately when negative markets do arrive.

We need to start by recognising the four features of negative markets.

1. Negative markets are essential to capitalism and are a naturally occurring feature of free markets

As long as there is capitalism, there will be times when economies undershoot or overshoot their long term trend lines. People and businesses will borrow too much money in good times, chasing opportunities based on overly optimistic projections and ideas that were, in retrospect, never justifiable. Recessions allow all the misallocated skilled labour, machinery, land and goods to be purchased, at discount prices, by stable businesses that can use them for more productive purposes. Those businesses become more profitable as a result. The economic cycle reverses and we come out the other side.

This cycle is both inevitable and healthy, as it reallocates economic inputs towards more productive activities. This is the nature of owning businesses in free markets, and it always will be.

2. Negative markets are very common

Looking at American data since the end of World War II, 70 years ago (which is also about the average age of the retired investor), there have been 13 negative markets where prices have fallen by nearly 20% or more:

Negative markets

So, if you plan to invest for another 30 years you can expect, more or less, about six more of these markets.

3. Negative markets temporarily interrupt a permanent upward trend

The idea of planning to avoid negative markets is absurd. As the table above shows, at its peak in 1946 the market index was at about 19. Today it's above 2,000. Despite 13 seriously negative periods in between, markets themselves have gone up over 100 times. An average 70 year old has seen markets go up 100 times in their lifetime alone! So what about the 'Armageddons' of days gone by? There have been oil crises, financial crises, the Cold War and killer flus, among many others, yet here we stand today at 100 times growth.

The fact is that the advance is permanent, while the declines are temporary. That may be all you need to know about negative markets.

4. Negative markets are the reason the returns of markets are so wonderful

For most developed nations since World War II, equity markets have returned at least double the returns of very safe Government bonds and bank bills.

Why is there such a big difference between the two?

There's principally one reason - equity markets are volatile. They can lose money a lot more easily and, as a result, equity investors are compensated with higher returns for holding those securities. This is a great trade off - higher return in exchange for higher uncertainty of where the price will be next year. For investors that don't need any more than a fraction of their money next year anyway, this is a trade off they're willing to make.

The irony is that the more uncertainty investors are prepared to bear regarding prices next year, the more certainty they'll have of their long term returns seriously outpacing inflation. This is a perfectly rational trade off for a long term investor. If price volatility went away, so would the extra return from owning businesses.

Benjamin Graham – the man who literally wrote the book on investing - said "bear markets (negative markets) are when stocks return to their rightful owners."

When undisciplined investors sell shares right in the middle of a price decline, who buys those heavily discounted shares? Smart investors; investors willing to buy more when shares are on sale.

And to quote Warren Buffett again, "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down."

The fact is, we don't know when the next bear market is coming, we only know that it is coming.

The only thing we can do is have properly diversified, appropriate portfolios ahead of time, and to rebalance those portfolios when it comes time to buy more shares at discount prices. By remaining disciplined and sticking doggedly to our long term plans, we can ride out any negative markets and continue to prosper with the wonderful advances free market capitalism brings.