—Jim Jorgensen
INVESTING FOR RETIREMENT usually means placing at least a portion of your money in the stock market. The reason is that, over long periods of time, it is highly probable that the returns from stocks will exceed the returns from most other asset classes, such as bonds and money market funds. In addition, stocks provide a hedge against the erosion of principal caused by inflation and taxes.
The extra gain expected from stocks is not without extra risk. There have been several periods when the market fell 20% or more in a short time and other periods when stocks did not outperform bonds or money market funds for a long time. When a deep bear market rolls around, it is often a brutal test of an investor’s nerves. Bear markets can be painful emotionally and financially.
Individual investors have no control over the direction of the market. The only decision is to be in or out. When you are in and the stocks fall, you lose money. When you are out and stocks rally, you miss an opportunity. But losing money is only one of the issues. Bear markets can cause anxiety, frustration, sleepless nights, a
feeling of hopelessness, and all kinds of uncomfortable side effects.
Due to all the bad stuff a bear market can cause, wouldn’t it be
wise to find a market expert who will magically get you out of bad
markets and into good ones? That is a nice dream, but it is not real-
ity. Market timing does not work. No one can predict the direction
of the stock market with enough accuracy to make any money—and
if they could, why should they sell their alchemy services to you?
Instead of trying to predict bear markets, investors should sim-
ply be prepared for them. Successful investing hinges on the devel-
opment of a diversified portfolio using an appropriate mix of low-
cost mutual funds. This portfolio should include U.S. stock funds,
foreign stock funds, bond funds, and real estate funds. A diversified
portfolio significantly reduces the impact of a bear market on your
portfolio, saving you money and makings you feel better as well.
Bear markets should only be a minor nuisance in your life and should have no effect on your retirement savings plan or your ability to sleep at night. They occur as a normal part of the economic cycle in every free-market economy and are a natural part of economic growth. If you live to be in your 80s or older, there is a good chance you will be involved in at least two lengthy bear markets during your life and many more short-term market corrections.
Bear Markets Occur More Often than We Think
When the stock market falls a lot, the mass media tends to talk about the decline like it is the end of the capitalistic system in America. Nearly every newspaper in the country prints a picture of some hum-
bled trader on the floor of the stock exchange, hands holding his head, in complete, utter shock. The caption below the picture reads, “Sell, Sell, Sell!” or “Market Breaks Support” or “Panic on Wall Street.”
tell the difference between a trader on the floor of the stock exchange and a trader in the commodity pits in Chicago. When they pick a file photo of a “depressed stock trader” for the newspapers, many times it is actually a picture of a commodities trader who has had a bad day trading pork bellies.)
News about movement in the markets is so editorialized that, depending on which news show you watch or which newspaper you read, the reasons given for the market decline could be vastly differ-
ent. A Los Angeles newspaper may report the market is down due to higher interest rates while a Chicago paper reports the market is down due to profit taking and a Boston paper reports the market is down due to poor earnings. Who is right? Who is wrong? Who knows?
The fact is that the market is down because there were more sellers than buyers, at least on that day. One day in July 2001, The Wall Street Journal actually reported, “With many traders on vacation, the market barely budged.” It is amazing what passes for news.
A market decline of 10% to 20% is known as a correction. Since Wall Street is paid to be bullish on stocks, the word “correction” is a nice replacement for the words “lost money.” When Wall Street firms say the market is “in a correction,” it is supposed to make you feel better about losing money because it implies the market is setting up for bigger gains in the future. Corrections occur on average every two years and generally coincide with some potentially harmful econom-
ic or global event, like Russia defaulting on its debts in 1998.
A bear market is a correction of 20% or more. It is widely believed that bear markets coincide with economic recessions. This means lower sales at retail stores and higher unemployment. The truth is, sometimes a bear market forecasts a recession and sometimes it does not. It did not in 1987, but it did in 2000. Economic data is always behind actual economic conditions, so we never know if the market is telling the truth. A standing joke on Wall Street is that the stock market forecast eight out of the last three recessions.
The following tables provide some interesting stock market data on negative years, market corrections, and bear markets in the U.S. The lesson to learn from this data is that bad market conditions occur more frequently than we think.
Interesting Statistics
_ Number of years the stock market was down more than 10%:
16
_ Number of years the stock market was down more than 20%: 8 _ Longest time for the stock market to recover to its previous
high: 14 years.
_ Longest time for stock returns to be lower than T-bill returns:
15 years
This Time It’s Different
Bull markets dim the memories of bear markets over time. During
long bull markets, people gradually forget that investing is risky and
instead begin to feel “this time it’s different.” At the end of the long
bull market from 1982 to 1999, some hot stocks began to look like
free ATMs, spitting out money month after month, with few inter-
ruptions. During this period, the investing public battled for posi-
tion in line to buy these risky stocks and the mutual funds that held
them. This behavior was highly encouraged by Wall Street firms that
make a lot more money when people buy stocks instead of bonds.
Mutual fund companies, insurance companies, financial magazines,
financial television shows, and every other industry segment that
benefited from more public participation in the market also cheered
as the market moved higher.
In early 2000, about the time a majority of investors started to
pin their worldly happiness on the daily close of the NASDAQ, the
floor dropped out. In disbelief, many investors reacted by purchas-
ing more shares of stocks that lost money, thus increasing their
equity exposure. This was perfectly logical at the time. A popular
mantra that worked well during the bull market was “buy the dips,”
so that is what people did. A few unfortunate investors even took
equity out of their homes to increase their exposure, believing that
now was their big chance to get in. All of this buying was not with-
out Wall Street urging. Experts called the pullback a “technical cor-
rection” and assured the country that a rally would soon take the
markets to new heights.
Well, the market did not recover as the experts predicted. There was a small rally in prices, and then a fizzle, and then another small rally, and then a big fizzle. At that point, there was doubt and confusion; smart money started selling. But analysts on Wall Street continued to pound the table, insisting that a rally was near. Alas, no rally developed; prices only went lower. Soon, more selling, as institutional traders rushed for the exit. Many small investors got trampled in the stampede, especially less experienced people who had never seen a bear market.
During a bear market, stocks usually decline much faster than they advance during a bull market. As a result, investors lose money very quickly, which tends to lead to a loss of confidence in the system. Depending on how much damage was done to a personal portfolio during a bear market, an investor could decide to stay out of stocks for a long, long time—and in some cases for life. The two worst bear mar-
kets in the twentieth century caused two generations of investors to shun stocks for decades. A large number of investors who borrowed money to buy stocks in the Roaring 20s got caught in the Crash of 1929 and never committed to the stock market again. Years later, many investors who were pelted in the brutal 1973-1974 bear market stayed out for years, despite a quick recovery in prices. The latest bear market has caused many people to cut stock exposure significantly and some people have vowed never to trust Wall Street again.
In Search of a Crystal Ball
You cannot predict the next bear market. Nevertheless, human
beings want to believe that somehow they can find a way to know
when to get in and when to get out. Vast amounts of time and
money are spent looking for undiscovered information or unique
trading strategies that have predictive value. But, so far there are no
winners.
The people looking for a crystal ball are no dummies. The list of
Nobel Laureates who lost money trying to find a mathematical solu-
tion is quite long. John Nash, Robert Merton, and Myron Scholes are
three who come to mind. Nash tried to develop market-timing sys-
tems using mathematical models based on game theory, for which
he won the Nobel Prize. He did not succeed. Merton and Scholes
were the architects of intrinsic formulas that mathematically predict-
ed the risk and return in hundreds of markets. Those models even-
tually led to the 1998 collapse of Long-Term Capital Management
(LTCM). The failure of LTCM was so potentially devastating to the
global economy that the Federal Reserve had to orchestrate a bailout
by several Wall Street firms. So, is there a crystal ball that can predict
the market? If Nobel Laureates cannot find one that works, then
there is no point for us to try.
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