The conventional definition of a bear market is a drop of 20% from its peak. Therefore, even though the S&P 500 is down by 18.6% since its January 3, 2022 highs, the index has not yet crossed the bear market threshold. However, several other US stock market benchmarks, including the Nasdaq 100 Composite Index, are already in a bear market and many components of the S&P500 index have lost much more than 20%.
As the Fed plans to combat inflation with a one-two punch of interest rate hikes and quantitative tightening, economic forecasters surveyed by Bloomberg currently assign a 30% probability to a recession within the next 12 months. Given these facts, investors must consider the possibility that financial markets will remain under pressure for a prolonged period.
What options do investors have, if the current correction officially turns into a “bear market?” History and experience offer some guidance.
Selling out is not the answer.
A decline in the market value of one’s portfolio, even if temporary, is never a pleasant experience. Pulling out of the market is not the solution, however. Empire Financial Research has calculated that over the period 1990-2020, only 25 trading days out of nearly 8,000 accounted for almost 80% of returns. Being out of the market on only a few such days can significantly dent your performance.
The next substantial single-day gain may occur as the market bounces off the bottom. The chances of getting back in at precisely the right moment are minimal, while the probability of missing a substantial portion of the rebound is far from trivial.
Bullet-proofing investment portfolios
“Bullet-proofing” our clients’ portfolio means taking the following actions. These will help limit losses but not entirely insulate the accounts from market fluctuations.
Reassessing and ensuring that all clients are adequately diversified and own portfolios consistent with their respective risk profiles.
“Pruning” positions. When market conditions change, one should not refrain from aggressively eliminating positions that no longer serve a role in the portfolio. It is not uncommon for investors to suffer from “breakeven-itis,”a syndrome that will make them uneasy about selling a position at a loss. Successful investors always look forward, never backward.
Reassessing the thesis for risky positions (individual stocks). Investing in stocks for appreciation comes with significant risks. The potential gain on a risky investment should always be 2 or 3 times the possible loss.
Reviewing position sizing. The positions should be sized so that the possible loss from each one is constrained.
Stress-testing risky positions and the portfolio using history as a guideline.
Our approach to stress-testing
In more ordinary times as well as now, our process for considering a stock for purchase or continued holding begins with a rigorous examination of the business, management, and the company's financials. We then calculate an expected rate of return (ROR) for the stock.
The expected rate of return for a stock is calculated by forecasting five years’ of earnings per share (EPS), at a growth rate based on either historical experience or the analysts’ consensus. Next, we multiply the forecasted five-years-out EPS by an assumed price-earnings (P/E) multiple to forecast the share price five years hence. The multiple we apply is the stock’s average for the past five years.
Finally, we discount the projected five-years-out price to the present, at 8% per annum to calculate a fair value for the stock today. (The 8% discount rate, which is roughly equivalent to the S&P 500’s annual rate of appreciation over the past 25 years, represents a fair market return for equity risk.) As long as the stock’s current price is not higher than this fair value price, it represents an acceptable purchase. A current price below the fair value price indicates a potential to earn more than a fair return on the stock.
These are exacting and conservative standards, but in the current environment, we have gone a step further by conducting a stress test on every existing equity portfolio holding. For the EPS growth rate, we applied the lower of the historical rate and the analysts’ consensus. Similarly, the P/E multiple we applied to EPS five years out was the lower of the current and the five-year historical average. By applying these tighter criteria, we believe we have accounted for most adverse scenarios other than two we consider unlikely at this point: (1) A secular decline in P/E multiples to the deeply depressed levels of the stagflationary 1970s. (2) Zero EPS growth for American public companies over a five-year period.
Our stress test give us the comfort to hold stocks with a reasonable expectation to profit over time, despite harsh market conditions.
For more risk tolerant investors
More risk tolerant investors may seek to profit from the market downturn by taking short positions. This is something that we generally discourage for the average investor. In our experience, the timing of such short positions often works against investors. At the apex of pessimism (when everyone is ready to throw in the towel), investors may feel the need to limit their losses while markets may rebound sharply and punish them.
Conclusions
As the inflationary pressures persist and the US Federal Reserve takes aggressive actions to rein in prices, we may be entering a bear market. History shows that selling out of investments completely is a costly mistake. A better approach is to reassess the construction of an investment portfolio and the selection of securities. An aggressive purge may or may not be necessary. More risk tolerant investors may choose to manage risks by entering short positions. Over the long-term these rarely add to performance.