Insights
Why We Do Not Sell During a Bear Market
As you are well aware 2009 has seen the investment markets continue the decline begun in October 2007. In this writing I would like to address for you why I do not suggest we sell and go to cash even though the market seems to go down every day and the economic news just gets worse.
If I were omniscient I might know that the market was going to continue to decline. So I would sell everyone’s investments, go to cash, watch the market continue to fall, and then swoop back into investments once I knew the market was about to rebound. But note that (a) I am not omniscient and (b) two separate decisions have to be made correctly in an effort to realize this scenario. The first question is when do we sell? Well I suspect you’ll agree that it feels like we should be selling right now. It does appear that the economy will get worse before it starts to improve and that stocks will continue to decline. Our Fed Chairman Ben Bernanke said last week that the economic recovery is not expected until 2010. Well let’s assume that’s the easy decision and that we sell today and go to cash. Now assume that tomorrow it looks like the right call because the market continues it descent.
But we must also discuss the challenge involved in buying back into the market. It is very unlikely we would buy in at a level lower then we got out. The reason for this is that if the market is continuing to fall, things are looking even worse then they do today. If we got scared out at DOW level X we are not likely to be happy about buying back in when things look worse. We are trying to avoid buying when the market may continue to fall so we would only buy back in when the future looks bright.
But the problem with this is that “the future looks bright” is only realized in hindsight. Frequently the end of a recession is officially called many months after the fact. In the meantime, it is very likely that there will be false market run ups, bear market rallies they are called. These bear market rallies can easily entice us back into the market only to realize later the rally would not be permanent. Imagine if we buy in during a run up that is ultimately a simple head fake and we end up buying high just before another ride down.
So before we can ‘comfortably’ buy back in, we would need to let the market run up for a while. The problem here is that following a bear market investments tend to run up very fast. To know why, we need to understand the term “Market Capitulation.” For the market to bottom during a bear market there needs to be “capitulation.” This is basically where all investors who are considering selling throw in the towel and give up. This is usually when things look the darkest. There is heavy trading volume and things are very scary. Once the sellers are gone it is easy for the market to rebound. Market Capitulation is something that is identified after the fact.
During the bear market cash builds up waiting to reenter the market (this is happening now in a big way). Once it begins to look like investments have bottomed some cash will reenter the market. Since most sellers are gone, a small amount of buyers can move the market up fast. Once the market starts to move other buyers will come back and before you know it, there is a feeding frenzy. The market will frequently be very volatile, but to the upside.
I would assign my ability to get you back in early in this process as slim to none. More likely, understanding the importance of getting in early, I could succumb to a head fake and buy in at the wrong time. If we go back in higher then we got out that difference can never be made up.
|
Period |
Market Decline |
DJIA Change 1 Year After Decline |
DJIA Change 2 Years After Decline (cumulative) |
|
Dec 1961 – June 1962 |
(27.1%) |
32.3% |
55.1% |
|
Feb 1966 – May 1970 |
(36.6%) |
43.6% |
53.9% |
|
Jan 1973 – Dec 1974 |
(45.1%) |
42.2% |
66.5% |
|
Sep 1976 – Feb 1978 |
(26.9%) |
9% |
15.1% |
|
Aug 1987 – Oct 1987 |
(36.1%) |
22.9% |
54.3% |
|
July 1990 – Oct 1990 |
(21.2%) |
26.2% |
32.6% |
|
Jan 2000 – Mar 2003 |
(35.8%) |
34.6% |
43.2% |
|
Average |
(32.7%) |
29.4% |
45.8% |
|
Oct 2007 – Feb 2009 |
(51.0%) |
? |
? |
Source: West Coast Asset Management.
What makes market timing impossible is due to what trader and philosopher Nassim Nicholas Taleb calls “black swans” – events that are hugely important, rare, unpredictable, and explicable only after the fact. See enclosed article “Why Market Forecasts Keep Missing the Mark.” We may get scared out of the market today then the next day the Federal Government releases a solid plan to get banks back on track and the market could be up 10% that day. Or in April companies report earnings higher then expected and the market is off to the races, without us. Or consumers increase spending (as was announced today for January although it didn’t help much this time, next time it could be a catalyst).
Lastly, and this is likely the most important thing I would like you to remember, the long-term market investment performance has always been positive despite occasional deep declines such as we are experiencing today. The farther the market falls now from its historical upward trend line the faster it will likely recover. I was reading today that one money manager claims that based on his yadda yadda analysis (I’m not making fun of his analysis, I just don’t feel like explaining it and the enclosed article should make you leery of anyone’s analysis) the market may fall another 20%. But, and here’s the thing, if it does fall another 20% his analysis would then expect the stock market to return 14 – 17% per year over the next decade to catch up. Should we stop our decline here, the market would be expected to increase 9% - 11%. This is just a fancy way of saying the more we go down the more we’ll go up later. So keep in mind that the markets overreact but ultimately regress back to their long-term trend, which is up.
I completely understand that it is nerve wracking to watch your investments decline. But you are diversified over thousands of securities all over the world. Along the way some companies you own will, in fact, go under. But many of the rest are simply becoming undervalued. As the economy recovers you can be assured of owning the survivors, and future market leaders, and participating in the ensuring market run up.
So in summary; the reason I do not move you to cash despite all the doom and gloom predications is that I do not know when there will be some “Black Swan” that will move the market up quickly. If I were to sell, you should accept that I am unlikely to buy you in later at a lower price because the lower price indicates fundamentals have only gotten worse. The economy will only be scarier. The world will look that much closer to the end. We would instead stay out of the markets until it is “safe”. But by the time it is safe to invest, the market will have run up without us. The reality is that there is a real likelihood of getting in at a higher price then we go out at. This difference can never be recaptured. It is a permanent loss that will affect your future standard of living. The only way I know to ensure we catch 100% of the next expansion is to be there when it starts, not sitting in cash. The only way I know how to ensure you capture long-term market returns is to be in the market. Not get in and out and back in again.
Lastly, if it helps, I am not any happier that the markets have declined then you are. But I know the decline is temporary. Try to accept this and try not to get caught up in world-is-coming-to-an-end predictions screaming at you from the TV. The world isn’t coming to an end.
I would love to tell you that the decline will end soon. But I don’t know. I do know that investment markets and the economy are decoupled over short periods of time so that the market can start its run up many months before the economy is back to full health. Investors just need confidence the end is in sight and the buyers will return.
I’ve enclosed some charts that show investment performance during contractions and expansions and during recessions, the dangers of market timing, and also the WSJ article.
Do not hesitate to call and discuss your account. I am always happy to hear from you.
