4th Quarter Client Note – Preparing for an Inevitable Bear Market

By Steven Smith | Financial Lifestyle

Jan 14

Global equity markets defied predictions – and perhaps even gravity – in 2017. The S & P 500 (total return) index increased 21.83%, landing in the top third best performances in its history. Foreign markets, buoyed by a falling dollar, performed even better. The MSCI World ex USA (net dividends) Index gained 24.21%. The MSCI Emerging Markets (net dividends) Index increased 37.28%, its fifth highest return in history.

And it was an uncannily smooth ride, with the fewest swings of 1% or more since 1965; the year Sandy Koufax won his second consecutive Cy Young award for the Dodgers.

But US Small cap and value stocks dramatically underperformed their large cap and growth counterparts, continuing a trend over the last decade or so.

In the bond market, the Barclays US Aggregate Bond Index gained a respectable 3.54%; reflecting .05% and .32% decreases in yields on the 10-year and 30-year Treasury securities, respectively.

For you data geeks, we have attached the Quarterly Market Review from our friends at Dimensional Funds Advisors. Also in this issue, in their musing at the end, Dimensional coherently chimes in on the Bitcoin mania. Should you buy some?

Inflation is Out There Somewhere

Unemployment has fallen to 4% from a peak of 10.2% since 2009. But wage growth and an uptick in inflation that normally accompanies full employment have been eerily absent due to global competition and technological advances. This has enabled the Fed to be modest in raising interest rates. How long that will last is anyone’s guess. But it wouldn’t be entirely surprising for inflation to tick up in the future.

When Will the Bear Growl?

First, a confession. I’m a lousy forecaster. But I’m not alone, according to this recent New York Times article, When Forecasters Get It Wrong: Always.

I thought it would take much longer to recover from the 2008 Great Recession. (It took about three years for a balanced 60/40 portfolio to reach its its pre-recession high.) And I’m also surprised that we haven’t had a bear market – defined as a 20% price drawdown – in the ensuing eight years. On average we experience a bear market once every 3.5 years and lasting on average 15 months. Thankfully, our investing process doesn’t rely on my – or anyone else’s – forecasting acumen. Instead, we build in resiliency and adaptation to prepare for likely events.

Fear, Greed and Complacency – Our Common Enemies

Investing in the depths of the 2008 financial crisis was easy. If…you had faith and courage. Faith in the basic structure of capitalism and in the future of America.  And the courage to take advantage of generationally low prices. Well, maybe not that easy.

Since the 2009 lows of the financial crisis the S & P 500 has climbed nearly 250%; the second longest and second strongest bull market in history. The first being the internet boom of the 1990’s. By virtually any measure valuations are high; certainly compared to the low valuations at the beginning of the bull market. We are probably not in a stock market bubble, like at the end of the dot.com boom in 2000, when P/E’s of the leading technology companies reached almost 100/1. But following nearly a decade of above average gains, it is a fair conclusion that the prospects for future expected returns are muted. We have no idea when this will begin to occur, what will be the trigger or in what form the future return patterns will emerge. We don’t know whether it will begin tomorrow or five years from now. It could be a sharp drop, followed by steady normalized returns. It could be a long, slow slog. Or something in between.

Strategies for Lower Expected Returns

While the see-saw of the market is something we have utterly no control over, there are myriad factors we can control that will go a long way toward determining our investment success:

What is Your Life Stage?

If you’re young and in the first innings of steadily saving and investing for retirement, a bear market is a blessing. You can buy stocks at lower prices and experience the luxury of higher expected returns. But if you are approaching retirement and are still healthy – and can stand your job – consider working a little longer or going part time. This will both add to your savings and forestall the need to start withdrawing from your portfolio. And consider delaying claiming social security until age 70. Payments are increased by 8% per year for every year you wait between ages 62 an 70.

Solid Investment Policy.

The most critical tools for managing your investments in any environment are having a well thought out long-term plan, committing the plan to writing (both an overall financial plan and an Investment Policy Statement) and sticking with that plan through market cycles. Periodically review your plan to make sure you are taking the right amount of risk to achieve your goals within your risk tolerance. (Remember the math of loss and recovery. A more conservative portfolio will fall less in a bear market and take less time to recover than a more aggressive one.)  And maintain broad diversification among and within asset classes; rebalancing when your asset allocations are outside the parameters laid down in your plan. (The current asset allocation of a portfolio that started out at 60/40 at the market bottom in 2009 would now be about 85/15.)

Needs, Wants and Wishes.

Have your absolute minimum critical spending needs (food, shelter and medical) at least mostly covered by guaranteed sources of income, such as social security and pensions and annuities. And be willing to have some flexibility in your spending on wants and wishes, such as travel and gifts. If you are subject to required minimum distributions, maintain funds for next year’s distribution in cash. Finally, have around a decade’s worth of supplementation to these guaranteed sources for spending invested in high quality bonds so that you don’t have to sell stocks in a low return environment that might last that long.

Watch Your Spending.

There is a well-developed body of research on Sustainable Withdrawal Rates through different market cycles; depending on various assumptions such as asset allocation, sequence of returns and spending rates. The so-called 4% rule was developed in 1994. Subsequent research has refined, expanded and criticized the rule. Utilize some retirement planning software to see how this research might apply to your own retirement under different conditions.

Hopefully, some of these suggestions will get your New Year off to a happy one and to a good start.

 

 

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