Five things you should know about bear markets

Bear markets can be frightening but they are necessary, Dan Hallett writes

By Dan Hallett
Globe Investor Magazine Online, Dec. 19, 2008

Dan Hallett, CFA, CFP is the president of Dan Hallett & Associates Inc, a Windsor, Ont.-based investment research firm. dha@danhallett.com

North American stocks have been halved. Overseas stocks have lost even more. Indeed, bear markets can be frightening but they are necessary. In order to enjoy the long-term rewards of investing in stocks, investors must shoulder the associated risks. One of those risks is the occasional emergence of a bear market (a decline of 20 per cent or more). To better understand this risk, here are five things you need to know about this unwelcome beast.

1. Bear markets are common.
Canada has seen six bear markets in the last 39 years. That's one every 6.5 years or so. The accompanying table shows that U.S. stocks have seen 15 bear markets over the last 137 years - an average of one every nine years. But that excludes a bear within a bear (i.e. where a 20-per-cent decline is followed by a further 30-per-cent loss before recovering). Including those, the average might be more like once every six years.

2. Clustered bear markets are the norm.
The accompanying table shows that most bear markets huddle together. (Canadian bear markets differ from those experienced by our American neighbours due to the prominence of resource stocks in Canada). Notice that many past bear markets started shortly after stocks fully recovered from the previous decline. Most investors' experience has, until this year, been the exception to the notion of clustered bear markets. The crash of 1987 was fully recovered by the summer of 1989. After that, the United States didn't have a real bear market until 2000.

3. This bear market started in 2000.
It seems pretty clear that the current bear market is of the clustered variety. Starting in 2000, the trip from peak-to-bottom-to-recovery took nearly six years. Yet, just 18 months after recovering, an even nastier bear market took hold. Admittedly, I was a little late to this realization. A few predicted this so-called "secular bear market" early on.

4. Diversification can save your ass(ets).
Even if you can see a bear market coming, there are always surprises. Indeed, one of the loudest voices in the secular bear camp was Eric Sprott. While he predicted the financial system meltdown, the strength of the U.S. dollar and the severe slump in commodities took him by surprise. His flagship Sprott Canadian Equity Fund lost more than half of its value (for the year ended Nov. 30), despite being able to short up to 20 per cent of the fund's value (where profits are obtained from falling prices). Sprott's traditional hedge funds have fared better.

The best place to hide has been in government cash and bonds. In the Great Depression, for instance, U.S. stocks fell nearly 90 per cent and spent 15 years under water. But a portfolio of 60 per cent U.S. stocks and 40 per cent U.S. government bonds spent just over six years in the red. There are two reasons for this.

First, the balanced portfolio lost a lot less than the all stocks portfolio. Second, deflation pervaded the 1930s and government bonds prospered, which helped the balanced portfolio recover quickly.

5. This bear will hibernate again.
The average U.S. bear market spent nearly three years recovering from its lows. This bear market is worse than average and the race downward has been much faster than a typical bear decline. The economic news will surely worsen from here but stock prices appear to be assuming the worst. Unless you believe that our economy will shrink over the next decade, stocks are cheap. And when fear abates, this bear will slip back into hibernation.

Special to the Globe and Mail