The Bad News Bears: Part 2 - Investing (Canada): 05/11/1998

Last week I reviewed the historical data on bear markets. They happen often enought to be concerned about them. And when they do happen, they can be devestating to one's financial health. The most recent major bear market in North America, the 1973-1974 bear, took over seven years for the stock market to recover its pre-bear levels. If your retirement plan calls for fifteen years of growth (as mine does) can you afford to lose almost half of that? Hardly.

And what happens if we suffer a bear market equivalent to the ones that have recently struck Asia, or that hit Japan in 1989? The Japanese bruin ate up over 50% of the market's value and has given back a pittance so far. It is still a shaky market. The Asian bears of last year and today also swallowed up 50% of the market value. The verdict is still out on whether those markets have started to recover. They're also still shaky.

A bear market is bound to happen some time. The question is when. So this week we take a look at some strategies to prepare for and cope with a bear market.

The Bear Necessities

As noted in Part 1 of this article, one of the problems with trying to prepare for and cope with a bear market is the folly of market timing. Most experts agree that it is next to impossible to predict what the market will do, at least in the short term. Over the long haul, markets will rise. And they will rise faster than the rate of inflation and faster than prevailing fixed income returns.

In fact, every bear market throughout history has been followed by a bull market that has taken equity values to new heights. That doesn't help, though, if we suffer a 1929 style crash and bear market. True, the market did recover to new highs, but it took 25 years to recoup lost ground. It wasn't until 1954 that the Dow again reached its pre-crash peak of 386.

Baby boomers like myself, who are within 25 years of retirement, cannot afford to wait 25 years to see our investments recover lost ground! So we need to be prepared, to adopt a strategy to cope with the future bear. Here are several strategies culled from articles on the Internet.

This is probably the easiest and most widely used method to prpare for a bull market. It is sometimes called asset allocation. Basically it means following the old adage "Don't put all your eggs in one basket." How you diversify sould be determined by your own unique circumstances, your risk tolerance, your age and so on. It may be wise to do this in consultation with a financial advisor if you are not sure what is best for you.

In an excellent article in Fortune in August 1996, Susan Kuhn writes that some unusual investments often outperform stocks during severe bear phases. From 1968 to 1979 stocks returned an average of only 3.1% a year. Gold, Chinese ceramics and stamps, on the other hand, returned a handsome 19% a year. During any particular period of time, some investments will outperform others.

She cites a Goldman Sachs study that showed a portfolio with 60% stocks and 40% bonds lost 9.6% during the worst 10% of times over a 25 year period. But if 10% of the portfolio were shifted to commodities, the loss was reduced to 5.8% as commodities gained 28.3% during bear markets. This is because inflation, which is poison to stocks and bonds, are beneficial to commodities.

She notes that diversifying the stocks you own is also a good idea. Her article is from an American magazine and suggests a mix recommended by an American firm for clients who plan to be holding their investments for at least 20 years. The mix is 34% U.S. Equities, 30% International and Emerging Markets, 24% in Real Estate Trusts, and 12% in Resource stocks. For Canadians, that should be modified to meet Canadian content requirements. Shift some of the American portion into Canadian equities and stay within the Canadian requirements by buying U.S. and foreign mutual funds that use derivatives to mainatin full Canadian content status. (See my deature on the Euro Funds from January.)

She also suggests holding sufficient cash to meet your needs for telve months (Ha! Easy for you to say! says I. That's a tough one to actually do.) And if you see large expenditures coming up in the short term, move investments into fixed income securities with maturity dates close to the time you'll need the funds.

If you monitor the monthly mutual fund performance charts, you may have noticed that, depending on the market, you'll find either some Global Manager Bear Funds or Global Manager Geared Funds in the Top 25 one month performers. The geared funds are highly leveraged. The bear funds focus on short selling. Global Manager, to my knowledge, is the only company selling funds in Canada that has bear funds. And for most people they are out of reach as they require a $150,000 minimum investment. But if the minimums were lower, would such a fund be worthwhile?

John Waggoner, writing in U.S.A. Today last October says no. "They're rotten in bull markets," he says, "and the market rises far more than it falls." His recommendation? Top performing diversified funds.

As noted above, the Global Manager funds are the only bear funds I know of in Canada. (If you know of others please send me a note.) But there are several American mutual funds designed to deal with bear markets. One with an excellent website is the Prudent Bear Fund managed by David W. Tice & Associates.

Besides explaining and promoting the Prudent Bear Fund, the site has an excellent collection of links to articles of bearish sentiment. It includes several by David Tice himself. One worth noting is How to Avoid Hype Stocks. In it he advises you to "never buy what a stockbroker tells (you) without doing some independent research ". Nor should one "blindly trust a brokerage firm". He suggests that a prudent investor should seek out a negative or neutral report from another brokerage to get a balanced picture.

Stocks often are hyped by brokerage firms and he cites the red flags to look for:

You may have read that Warren Buffett, the world's greatest investor, pays absolutely no attention to the stock market. When he invests, he invests as if he were buying the entire company. He looks for solid companies with a proven track record and a potential for continued growth that are currently undervalued by the market. He does not actively trade in and out of the market. Once he has made a purchase, he tends to hold it for the long term. Why sell the goose that's laying the golden eggs, he reasons.

Buffett's approach is my personal favorite. Mutual funds that follow a value investing approach are ones to invest in and hold for the long run. They are most likely to weather a financial downturn. And they are most likely to recover quickly from a bear market.

There are several fund companies that folow an explicitly value oriented approach. The mnst famous, of course, is the Templeton Growth Fund. This fund suffered a downturn of about 25% during the 1973-1974 bear as against the market as a whole which dropped about 50%. It recovered quickly in the subsequent years. It remains in the top funds for 15 year performance.

Similar success has been achieved by the Trimark Fund. It also pursues a value oriented approach. The Cundill funds too have excellent long term track records, though they have been underperforming in recent years.

Funds that profess to follow Warren Buffett's style include the AIC Funds, the Ethical North American Equity Fund, Investors U.S. Growth fund and the new Infinity Funds.

And, of course, you can just buy shares in Buffett's Berkshire Hathaway company. I bought two of the Class B shares about a year ago. Immediately they dropped from $1595 to $1400 and languished until January. But my oh my! Have they been flying since! B-H is up over 50% since January 1. This is a stock in my "don't sell until retirement" category.

In fact, it may be an interesting investment strategy to buy one Berkshire Hathaway Class B share a year until retirement. At an annual compounded growth rate of 20% (B-H has actually been doing better than that since 1965) a share bought today at the current price of $2300 US would be worth over $35,000 US in fifteen years. Redeemed in Canadian dollars, each B-H Class B share would be worth $49,000 in fifteen years. Probably enough for a year's retirement, but certainly enough to form solid base.

Two articles on the Internet promoting Value Investing as an approach to coping with bear markets are an Associated Press wire story from last April (no byline) called "Experts say bear market can be an opportunity" and Phil's Diary on a site for American doctors from September last year.

Phil's Diary is a particularly lucid account of the Value investing approach. Comenting on the idea of trying to sell before a crash and buying back in cheaply, Phil says "The above decisions are simply too hard to make for a mere mortal like me. If I am lucky enough to have bought into solid companies at reasonable prices, then I am better off telling my neighbour (in a bear market) where to go instead of selling everything before he comes." In fact, he suggests taking advantage of your crazy neighbour and buying more quality stock cheaply during a bear market.

Although I've been pooh poohing market timing so far in this article, there are some broad truths about the market that can be used in making some predictions about the future.

We know, for example, that an increase in interest rates will bring about a decline in the stock market. The reasons are simple. Companies borrow to build new plants, retool factories and so on. The interest paid on the loans is a cost that cuts into the bottom line. If interest rates rise, the interest cost increases and profitability decreases. Stock prices are earnings driven, so if earnings (profits) decrease, the stock prices must also drop.

There are other factors as well. We've all heard the expression "the trend is your friend" (momentum). There are such things as housing starts, employment figures and other economic indicators. All have some predictive value.

One company that has made a detailed analysis of these indicators is Lowrisk.com. They have built a proprietary computer program called the Lowrisk Market Allocation Model that takes in a vast array of data and spits out a number between 0 and 20. This number serves as a predictive indicator. The higher the number, the more bullish they are.

The model is completely computerized. They feed in the data each evening after the market closes to check the new Signal Strength. Lowrisk.com has built four portfolio strategies to act on the indicator and tested them out using back data. Each of their four portfolio styles serves a different purpose, and each beats a buy and hold approach in returns. The four models are the Disaster Avoidance Strategy, the Graduated Strategy. the Timing Strategy and the Superbear Strategy.

They are fairly simple strategies. Disaster Avoidance, as its name implies, aims at avoiding extreme bear markets and crashes. It trades infrequently having you 100% in equities unless the Signal Strength falls to 3 or lower when it moves you 100% into Money Markets.

The Superbear Stragey is the opposite. It has you in Money Markets unless the signal strength is 18 or higher when it switches you 100% into stocks.

The other two strategies fall in between these two with the Graduated Strategy being the most active trading model. These two strategies are tabulated below:

ModelSignal Strength

Allocation
Graduated	0-2	50% Money Markets- 50% Short
Graduated	3-5	100% Money Market
Graduated	6-9	25% Stocks - 75% Money Markets
Graduated	10-11	50% Stocks - 50% Money Markets
Graduated	12-14	75% Stocks - 25% Money Markets
Graduated	15-20	100% Stocks
Timing	0-2	50% Money Markets - 50% Short
Timing	3-13	100% Money Markets
Timing	14-20	100% Stocks

All of the strategies outperform a buy and hold approach and all of them have a lower drawdown or downside risk than a buy and hold approach. If their data and track record are accurate, Lowrisk is an approach to watch. To keep abreast of the Model, Lowrisk's Jeff Walker sends out the emailed Walker Market Letter. It is free and it is sent out on a regular basis and whenever there is a change in the signal strength. They also have a paid subscription newsletter for day traders.

Here is a chart of how the different strategies have done compared to the S&P 500:

YearS&P 500Disaster AvoidanceGraduatedTiming

Superbear
1983	3.2%	3.2%	3.5%	3.9%	3.7%
1984	6.0%	6.0%	9.1%	13.2%	9.6%
1985	31.1%	29.7%	34.1%	32.3%	35.0%
1986	18.6%	17.4%	17.7%	18.5%	15.4%
1987	5.6%	42.6%	60.3%	68.2%	23.4%
1988	16.4%	16.3%	15.5%	21.0%	15.4%
1989	31.3%	30.2%	33.0%	30.2%	27.4%
1990	-3.1%	6.9%	16.2%	15.4%	15.6%
1991	30.0%	29.8%	31.0%	33.5%	29.3%
1992	7.5%	7.4%	8.7%	6.5%	11.2%
1993	10.0%	9.5%	10.3%	10.1%	9.9%
1994	1.3%	0.0%	7.5%	10.3%	4.6%
1995	37.1%	36.5%	36.8%	37.1%	27.9%
1996	22.7%	21.9%	25.8%	26.5%	22.9%
1997	33.1%	31.5%	31.4%	30.4%	5.6%

Other important charts from Lowrisk.com which I am not reproducing here are charts showing the drawdown or downside risk for each strategy. In all of them, the downside risk is significantly lower than that of the S&P 500 and the Superbear Strategy shows the lowest drawdowns of any of the strategies.

Where is the Signal Strength currently (May 10th)? On April 23rd the Signal Strength dropped from 18 to 17 moving all the funds in the Superbear Strategy from stocks to money market funds. On May 7th the Signal Strength moved from 16 to 14 moving 25% of the Graduated Portfolio into money markets. And as I was writing this Sunday night May 10th, an Flash Update came in advising that the Signal Strength had slipped further from 14 to 12 moving 100% of the Timing Portfolio into money markets.

So the trend over the last few weeks has been down, even as markets are rebounding, and two of the Strategies are competely out of stocks. I have subscribed to the free Walker Market Letter for some time, never paying very close attention to it. In doing this article I've taken a closer look and will be re-assessing it, deciding if I want to follow any of the Strategies listed, and if so, which one, and making changes to my portfolio accordingly. I may continue to be a buy and hold investor, but the Lowrisk site certainly provides food for thought. Check it out!

Links of Interest

The Bear Hunt
A collection of links to articles with a bearish sentiment from the Prudent Bear Fund.

Phil's Diary
A superb article on taking a value investing approach to bear markets.

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions.

American Readers: Looking for a broker who can sell you Canadian stocks? One of my brokers is licensed to sell securities to Americans in 26 states. She works for Canaccord Capital which is an excellent company with a superb research department. They are particularly knowledgeable on resource issues. Send me a note if you want to get in touch with her.

I'll be adding a new Library category called Bear Necessities later this week where all this week's and next week's links will be archived.

You're invited to get my weekly emailed Newsletter in which I let you know what the upcoming article will be and of any significant changes and additions to this site.