Editor’s note: Paul Merriman originally published this column in early August, 2015 Then last week, Aug.24-28, stocks had their worst showing in four years. The Dow Jones Industrial Average closed Friday in correction territory, generally defined as a 10% drop from its most recent high. On Monday, August 24th, the Dow Jones Industrial Average quickly fell more than 900 points, topping the 530-point drop on Friday.
The carnage in the Nasdaq Composite has been far worse, with the index plunging more than 8% in early trade. With that in mind, here are his thoughts on what readers need to know about bear markets.
The last several years have been quite kind to equity investors, probably lulling too many of them into a false sense of security. But a bear market is almost certainly on its way. I can't tell you when it will show up. I can't tell you how severe it will be. I can't tell you how long it will last.
But I am pretty sure that the bear will pay us a visit sometime in the next year or two. I'm also quite sure that investors who are familiar with bears (bear markets, that is) will fare better than those who aren't.
So here, in no particular order, are 22 things I think every investor should know about bear markets.
1. What is a bear market? The term is sometimes thrown around loosely. But there's a real definition that's generally agreed on: A bear market is a downturn of 20% or more, lasting at least 60 days, in any broad equity index such as the Dow Jones Industrial Average, the S&P 500, or the Nasdaq. (Figures cited in this column apply to the S&P 500.)
2. If the 20%-plus downturn lasts less than two months, it's considered a correction instead of a bear market. (This doesn't mean it hurts less, but the pain starts easing up sooner.)
3. A bear market is triggered when investors lose faith in the market as a whole — decreasing the demand for stocks. This tends to happen when the economy enters a recession, unemployment is high and inflation is rising.
4. Bear markets are normal, but not predominant. Over the past 200 years, the stock market has risen more than it has declined. The bear accounts for only a minority of the history of the market — but that minority is pretty unpleasant.
5. Like earthquakes, bear markets are hard to predict, but especially hazardous to those who fail to prepare. Since 1929, the U.S. stock market has experienced 25 bear markets, an average of one every 3.4 years.
6. Statistically, we are overdue. The most recent bear market ended in March 2009 — more than six years ago.
7. Also like earthquakes, bear markets don't last forever. Those 25 bear markets lasted, on average, for 10 months.
8. Also like earthquakes, bear markets can be relatively mild or quite harsh. The average bear-market loss was 35%. The smallest loss was 21% in 1949; the worst was a drop of 62% from November 1931 to June 1932.
9. Many of today's investors have lived through two fairly nasty bears: a decline of 58% from 2000 to 2002 and a 57% plunge from 2007 to 2009.
10. Bear markets spook investors who aren't prepared for them. Millions of investors are still nervously on the sidelines following the market rout of 2008. By remaining in cash, they have missed out on a strong, sustained recovery
11. The history of the markets isn't entirely bad. The 25 bull markets since 1929 have lasted an average of 31 months — three times as long as the average bear market. Also encouraging: The average of these bull markets sent stocks up 107%.
12. Like bear markets, bull markets come in all sizes. The smallest bull-market gain was 21%; the largest was (hang onto your hat) 582%, from 1987 to 2000. That prolonged bull market started right after a sudden correction (widely regarded at the time as a crash) in which the market lost 22% in just one day.
13. The bear's bite isn't quite as bad as these numbers make it seem. For technical reasons, the returns cited here were computed without taking reinvested dividends into account. That means the losses were actually slightly less, and the gains slightly more, than the numbers would indicate.
14. Just as a bear market can scare off investors, a prolonged bull market can lead investors to think that market risk is nothing but an outmoded concept. Early in 2000, after nearly 13 years of a bull, millions of investors were stunned when a serious downturn began in the spring.
15. Bear markets don't last forever. I'm not saying it couldn't happen, but it hasn't happened yet. Perhaps the main reason is that broad market indexes are made up of so many stocks.
16. I know of one guaranteed way to absolutely protect yourself from a bear market: Don't ever invest in equities. However, this guaranteed protection has a high cost: You'll never obtain the gains from bull markets.
17. A better way to protect your assets is to diversify among many equity asset classes. This worked very well from 2000 to 2002: while the S&P 500 dropped more than 50%, my recommended equity portfolio fell only about 14%.
18. A third (and very effective) way to protect your portfolio from a bear market: Add bond funds. Over the past 45 years, the worst calendar-year performance for a combination of 40% diversified equities and 60% bonds was a loss of 14.9%, in the devastating year of 2008.
19. Better than either 17 or 18: Do them both.
20. Young people should welcome the bear. This sounds counterintuitive, I know. But young investors are blessed with lots of time. They need the long-term growth that results from buying stocks when they are less expensive so they can (eventually) sell them when they're worth much more. A bear market makes stocks (temporarily) less expensive; this is when young investors should be buying all they can.
21. New retirees, on the other hand, should be particularly wary of the bear. If you retire just before the start of a bear market, the decline will rob you not only of a big chunk of your life savings after you have lost much of your ability to replace them. It may also rob you of the confidence to remain invested in equities, which retirees need to stay ahead of inflation.
22. Bull markets and bear markets look pretty dramatic when you see them in a graph. This article, though it's a couple of years old, contains a chart that does a wonderful job of showing what I mean.
The point of all this information isn't to depress you, but to warn you. After a long bull run, it's easy to get complacent. Don't do it.
My advice is simple: Keep your expectations in check, be patient, and take the long view.
