Recognizing and Preparing for the Bear

Investing in a Bear Market. Getty Images

Which are the best mutual funds for a bear market? Are there certain types of stocks or bonds that perform better when the market is in decline? When is the best time to begin preparing for a correction? What are signs a new bear market is near?

Understanding Stock Market and Economic Cycles

There is no magical bell that rings when a bear market for stocks begins. This is what makes market timing tricky and not generally recommended. But you don’t have to time the market in the absolute sense to minimize risk when a decline appears to be on the horizon. Also, it’s not a good idea to move completely out of stocks and bonds and into cash because it is nearly impossible to guess the best time to get back in.

So where does one begin to make the best planning decisions for investing in a bear market? if you understand the difference between market and economic cycles, and how they are related to investment performance, you can determine the best timing strategies and portfolio structure that works for you.

For example, you may want to begin preparing your portfolio for a bear market before it begins rather than wait until you know for certain stocks are officially in a bear market. You don’t want to prepare for the storm when it is already upon you because making changes at this point can potentially do more harm than good.

What is a Bear Market?

Before you plan for a bear market, it is important to understand its nature. Most investors have a basic understanding of the term but what is the definition of bear market and how long does it last?

A bear market can be defined as an extended period of time where investment security prices are generally declining. Most commonly, the term bear market describes a negative environment for stocks but the term can also refer to other investment securities, such as bonds or commodities.

The length of time that the period of generally declining prices lasts is called the duration. Historically bear market durations have ranged from approximately 3 months up to more than 3 years. Most bear market durations are longer than 1 year but shorter than 2 years.

With exception of hindsight, no one knows exactly when a bear market begins. But a clue that says a new bear market is getting closer is when the Federal Reserve begins to raise interest rates again after a period of lowering them.

You may have heard the old investing mantra, Don’t fight the Fed. What this means is that investors can do well to stay fully invested (up to their respective risk tolerance, of course) when the Federal Reserve is actively decreasing interest rates or keeping them low. In this environment corporations can borrow money at low rates, which often translates into more profit as they invest the borrowed money in technology, or simply to refinance debt from higher rates to lower rates.

But when the Fed starts to raise rates, it means the economy is healthy and maturing, which is typically toward the end of a growth cycle (and hence closer to a bear market and recession).

Therefore a bull market for stocks typically peaks before the economy peaks. This is because the stock market is a forward-looking mechanism a discounting mechanism and a leading economic indicator. In different words, the stock market will begin its bear market decline before it is officially announced that the economy is in recession. In simple terms, stock prices today reflect investors’ best guess as to near-future conditions, whereas economists and the Fed look back at the recent past to guess current economic health.

Now consider that the average duration (length) of a bear market for stocks is one year. By the time economists herald the news that a recession has begun, the bear market may have already been in place for three or four months, and if the bear market decline is below average in duration, the worst may have passed. In different words, a new bear market for stocks can begin even as the economy continues to grow and a new bull market can begin before the recession is officially over.

Watch the P/E Ratio on the S&P 500 Index

Although this is not a consistently accurate means of predicting short-term stock market fluctuations, the price-earnings ratio, also known simply as the P/E, of the S&P 500 Index can be used as a general barometer for determining if stocks may be overbought or oversold. Put simply, if you learn how to interpret the overall value of stocks by using the P/E ratio on the S&P 500 you can gain insights into the value, and hence, the future direction of equity prices.

For reference, the average P/E ratio for stocks since the 1870’s has been about 15.00. This means that, if you take the average price of the large-cap stocks in the S&P 500 Index and divide that collective price by the respective mean earnings, you get the P/E for what most investors call the market. If this P/E is significantly higher than 15.00, it is reasonable to expect stock prices to fall at some point and if the P/E is lower, you can expect prices to rise.

A simple way to get the P/E ratio of the S&P 500 Index is either by a simple Google search or by looking at a quote online for any of the best S&P 500 Index funds .

Keep a Smart Balance With Tactical Asset Allocation

Before getting to the actual funds for investing in a bear market, consider how you may structure your portfolio as a whole. This is the tactical part of portfolio construction.

As you already know, it is not wise to attempt timing the market by jumping in and out of stock and bond mutual funds but it can be smart to make small and deliberate steps by adjusting the asset allocation of your portfolio.

Asset allocation is the greatest influencing factor in total portfolio performance, especially over long periods of time. Therefore an investor can be just average at investment selection but good at tactical asset allocation and have greater performance, compared to the technical and fundamental investors who may be good at investment selection but have poor timing with asset allocation.

Here’s an example of tactical asset allocation: Let’s say you see classic signs of a maturing bull market, such as high P/E ratios and rising interest rates, and a new bear market appears to be on the horizon. You can then begin to reduce exposure to riskier stock funds and your overall stock allocation and begin building your bond fund and money market fund positions.

Let’s also assume your target (or normal) allocation is 65% stock funds, 30% bond funds,and 5% cash/money market funds. Once you see P/E ratios at high levels, new records on major market indexes. and rising interest rates, you may take a step back in risk to 50% stocks, 30% bonds and 20% cash. All that remains is the actual mutual fund types that can help reducing your overall portfolio’s market risk .

Continue to page 2 to find out which funds are best before and during a bear market.