January 13, 2020

The Bear Market as an Opportunity for Growth

There’s nothing that strikes more fear into the hearts of investors than market declines. Short-term or long-term, it almost doesn’t matter. This is particularly true of investors whose portfolios consist mainly of equities or equity-driven assets (i.e. index funds). The problem here is that most investors can’t tell apart the “bearish” from the “bear.” Unable to distinguish a deep correction–the proverbial “Wall of Worry”–from a bear market, many investors end up selling their positions just moments before a bull market advances to greater heights.

It seems as if distinguishing a correction from a bear might serve as a critical solution to the problem. Perhaps, it is. Investors might then be able to “time” their portfolio rebalances, if such accurate timing was even possible.

You might think this a crazy question, but is a rebalance even necessary? Going against the grain of popular wisdom, might holding on during a bear market provide opportunities for growth? And might holding a diversified basket of commodities enhance that growth?

What if both cases were true? If so, then bear markets might actually present favorable opportunities: one for “growth” (simply by sitting tight) and the other, even greater growth (by sitting tight and allocating a portion of your portfolio to commodities). Doubtful? Let’s explore these ideas further. First, let’s get to know the bear just a little bit better.

Characteristics of a Bear Market

A bear market is a stock market downturn of around 20% or more that occurs over an extended period of time. Bear markets are fundamentally-driven–not sentiment-driven.

Unlike corrections, which can be steep, unexpected, and (therefore) frightening, bear markets tend to begin slowly, market euphoria making the bear’s entrance nearly imperceptible. Also, the effect of euphoric sentiment tends to leave its tracks on a price chart–a  “rounding off” shape before the initial plunge. But even the meaning of that initial plunge is uncertain, as bear market declines take place across a series of gradual plunges, interrupted by optimistic episodes of “bear market rallies.”

When a genuine bear strikes, the market loses approximately 2% each month on average. This may sound like an easy measure, but then it would require an investor to wait at least three months to ensure they’re not caught in a severe correction. Not an easy task.

Another commonality between bear markets is that the first two-thirds of a bear’s duration are when the smallest declines occur. It’s in the last third of a bear market that investors enter into panic-selling mode. Of course, you can see the irony here: the last third of a bear market is when most institutions may begin “buying” into the panic.

But here’s something to think about: what if an investor simply held on during a bear market? Would they have lost all of their gains only to begin again in the next bull market? All you have to do is to look at the averages.

Since the end of World War II, the S&P 500 has had eleven bear markets.

  • The average bear market decline was around -34%.
  • The average bear market duration was around 16 months.

If that sounds bad, compare these to the average bull market figures.

  • The average bull market measured across the same period has averaged 149%.
  • The average bull market duration stands at around 57 months.

If you do the math, comparing 149% to -34% on average, and 57 months (bull market) to a mere 16 months (bear market) on average, then the answer to the questions above may be rather clear, don’t you think? Based on historical data, an investor who simply held on through bull and bear might have come through far ahead over most investors who had sold (and failed to get back into the market).

If this news surprises you, it’s because most equities advisory firms don’t really mention it (they wouldn’t be generating commissions without portfolio rebalances).

So where do commodities come in? Can they be used to enhance rather than just “hedge” your portfolio?

Commodities – Hedge or Additional Return Source?

It would be a mistake to assume, as many investors do, that commodities have a negative correlation to the stock market–that commodities rise when the stock market falls. All you have to do is to look at historical data to see that sometimes commodities do rise when equities fall and sometimes commodities rise when stocks rise and fall when stocks fall.

So, what’s the point of it all? Simple, it’s about diversification–not just as a portfolio hedge (though sometimes that can happen) but as a means to widen return sources.

During the bear market between January 1973 and October 1974, when the S&P 500 fell -48%, the GSCI Commodity Index rose 107.54%, likely due to soaring energy prices. During the bear market following the 2000 Tech Bubble, from March 2000 to October 2002, the S&P 500 declined -49.1% while the GSCI Commodity Index rose 14.56%.

A nice hedge, but the two market didn’t always move in negative lockstep.  During the bear market of 2008 that led to the Great Recession, the S&P 500 fell -56.4% while commodities also fell -40.41%. But in the years leading up to 2008, as stocks saw a bull market, commodities were also experiencing a boom–a cumulative gain of 68.57%. And as of last October, with all three major indexes continuing to make new highs, commodities logged in a gain from January to October 2019 of 10.64% according to GSCI Commodity Index data.

The Bottom Line

Bear markets are much less frightening when put into perspective. You can choose to avoid them, but don’t get caught in the trap of selling assets during a mere correction only to miss the next leg up (or selling during the final moments of a bear only to miss the next bull). That’s typically what most investors do. Remember the words of Sir John Templeton: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Also, think of commodities as an additional diversified return source rather than a hedge. Otherwise, you may be disappointed when commodities don’t act like a perfect hedge, leading you to exit the commodity markets right before they undergo another bull market. Remember, commodities may rise when the broader market falls. But they can also rise when the broader market rises as well.

It’s all about participating in a wider pool of market opportunities rather than seeking a defensive safe haven. Besides, historical data shows that bear markets are on average much smaller and shorter than the average bull. Bear markets don’t wipe out portfolios–investors’ fear-based responses do.

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