Surviving the next bear market crash

The information below is taken from a professional investor investing since 1998, and an amateur in the years prior. He had the misfortune to witness two and a half bear markets up close and personal, and many more from afar. He will walk you through the signs of a bear market, what action you should take, and some clues as to how and when they will end. 

And, he will also take you through some of the mistakes he made in past bear markets, and the lessons learnt. The most serious of all has been the reluctance to do precisely nothing. You’ll see that patience is a virtue, that good ideas are dangerous, and that liquidity is key.

Markets and news work in reverse

Markets and news work in reverse. It can sound counter-intuitive, but good news is abundant at the top, whereas at the bottom, the end of the world is nigh. As a result, the emotional turmoil during bear markets can be horrendous, and your worst enemy is yourself: this is something I have learnt the hard way. 

When you see glimmers of hope, that will turn out to be an opportunity to sell, just as the market is about to drop like a stone. And when you see metaphorical blood on the streets, and the temptation to sell, it is normally time to buy. As I learnt in the army, war is 99% boredom, and 1% chaos. We are talking about money rather than lives, but the market reflects livelihoods, and I believe there are parallels. 

And that’s why you need patience and a plan, because it can be expensive to listen to your gut instincts. The more you trade, the more you stand to lose. And the greedier you are, the worst the results will be. As Warren Buffett said, “Be greedy when others are fearful, and fearful when others are greedy.” 

On the surface, what happens during bull and bear phases is essentially the same; the market is simply digesting the available information and setting prices as to how the world might look one or two years from now. I stated that good news comes at the top, but to pull back another layer, it is normally heavily disguised by bad news. Why? Because good news doesn’t sell papers. 

Pre Covid-19, the recent financial news talked about the perils of Brexit, Italian debt, Federal Reserve tightening, China and ballooning credit. All of these are real fears, yet the duller and more relevant story for the market, barely gets a mention. Remember, we were enjoying record levels of employment, improving public finances and relatively few bullets being fired around the world, when compared to times past.

This is where the adage that “bull markets climb a wall of worry” comes from.

Investors tend to worry about bad things that may happen years into the future, and ignore the good news around them today. Markets, on the other hand, don’t seem to care for what may go wrong down the line. They just price in what they see in front of them. 

Just as the bulls climb the wall of worry, so bears “slide the rope of hope”. Once the emotional state of investors changes, the actual news sees jobs being lost, public finances in a mess and geopolitical threats all around us. 

At this point, investors make the classic mistake of seeking green shoots. That might be a positive outlook from the International Monetary Fund (IMF), the impact of increased government spending or even lower valuations. But yet again, the investors might be right in that these good things will eventually come, but the market doesn’t see them today. And so, prices fall, often by much more than they should. 

The bottom line is to watch the things that matter. And nothing matters more than jobs and public finances. Even GDP, which I have criticised before, is inflated by government spending. When things turn down, it is the private sector, which generates the wealth of the nation, that we must measure. And that’s all about jobs, taxes, production, deficits and prices. 

Calling the top

In late 2007, I scored a metaphorical six. I sold out of the lofty Asian markets within three days of their peak. I went into 2008, with a light equity allocation and felt in control of events. That was a terrible mistake. Not selling equities at the right time, but thinking I was in control. 

My mistake came that summer in thinking it was time to buy after a modest dip when the then Federal Reserve chairman, Ben Bernanke, had already cut rates from 5.25% to 2%. The Asian equities I had sold were already down by 28%. 

Many senior economists and strategists felt that the market had the stimulus it needed to thwart off a recession. How wrong they were. Rates went down in September until they touched 0.25% accompanied by the Troubled Asset Relief Program (TARP) and quantitative easing (QE – effectively the creation by central banks of money out of thin air in order to buy bonds). And those Asian equities fell another 50%. 

The early stimulus did nothing, as jobs were still being destroyed and the government deficit was still rising. Bear markets take time, and sometimes, the tricks to prevent them fail. My regret was having too much confidence in the system around me. 

I felt that those at the helm knew what they were doing. It was obvious that the banks were in crisis, as that summer RBS had already lost two thirds of its value. Surely that was enough? But it wasn’t over until it was over. I had been lulled into a false sense of security, by incompetents that were trying to shore up confidence – at investors’ expense

Don’t listen to the authorities. Ignore the IMF, the Confederation of British Industry, the World Bank and the analysts. Their job is to tell you that all is well. For when did they ever say things were getting worse? If you want to spot a bear, don’t ask them, for they either don’t know, or if they did, they would never say it.

The difference between bulls and bears 

On the face of it, it can be hard to notice a bear market: on a typical day, the chance of the market rising or falling is approximately the same. If you were living and breathing markets, would you barely notice the difference between a bull and a bear. 

But those fewer up days were enough to skew the trend. More importantly, the down days during the bear can be devastating. When you look back at the tally, the worst of a bear market comes down to a handful of very bad days at the office. 

Recall the bear market following the bursting of the technology media and telecommunications (TMT – or “dotcom”) bubble at the beginning of this century. What was really happening was an economic slowdown, which was combined with a fall in valuations following an era of exuberance. The terrorist event, the corporate accounting scandals and the Gulf War were seemingly unrelated to the economy or the market. But these external events were triggers for a sell-off, at a time when investors were anxious. 

Indeed, the second Gulf War in 2003 marked the end to that three-year old bear market, as the rally began just as the first shots were fired. Sometimes horrific events don’t budge markets, yet at other times, they can dominate them.

The US market made its final WWII low four months after the Japanese bombed Pearl Harbor, and then rallied for the rest of the war. Then, a few months after the celebrations for victory over Japan, the market collapsed. 

It is unsurprising that people find markets a conundrum. What happened? The end of the war saw the end of price controls and inflation spiked. Share prices didn’t like it because profits came under pressure. But that era didn’t see a bear market, merely a lull in the trend as prices fell in real terms. The time to buy was in 1949, but I don’t suppose many of us will remember that. The time was clearly marked by a change in trend.

Respect the trend

The trend is the combination of trailing prices over recent history. It doesn’t define what will happen, as it only measures what has already happened. But a quirk of markets is that trends tend to persist for longer than you think, presumably because investors take time to adapt to a new environment; hence the adage that “the trend is your friend.” But in recent decades, computing power has become vast and widespread. 

Source: Bloomberg – BarclayHedge CTA Fund of Funds Index (black) and the MSCI World Index (red) since 1980 in US dollars

Simple trend-following strategies, which were once a licence to print money, have struggled. And ever since the credit crisis, trend following, as a strategy, has struggled to make money… that is until recently. 

I highlight this chart because it shows you the performance of a group of CTAs (an acronym for commodity trading advisers or trend-following funds), which became a popular choice for investors that want to avoid the bear. 

A typical strategy has seen them buy what rises higher, and sell short what falls lower. The classic strategy is that of the “turtle trader” which focuses on six- month highs and lows. According to the rules, a new high is always a buy, and a new low, a sell. That might sound simplistic, but you’d be amazed how this simple strategy has worked so well, making billionaires of people like John Henry, who now owns the Boston Red Sox and Liverpool FC. I can promise you that he didn’t make his money from sport. 

I have always been a fan of the CTA concept, and was pleased to own them during the credit crisis on behalf of my clients. But this chart, which shows you the returns from global equities (including dividends) compared to a basket of trend- following funds, tells you a number of things about how markets have changed. 

Firstly, trend-following funds (with high fees) have matched the returns from global equities (without fees) in all but the most recent decade. Secondly, they have kept out of trouble during bear markets – a key point they have kept out of trouble during bear markets – a key point that is illustrated by their big returns when the stockmarket fell. Lastly, something has gone terribly wrong with this strategy since the credit crisis.

Why? Low interest rates around the world has created a world devoid of trend. It is interest rate differentials that drive currencies and bond markets, and therefore all assets. Whilst they were all fixed at zero, it has been tough for these strategies. 

The trouble is that in today’s market there are far too many computers second guessing everything. But long-term trend-following strategies do work, and always will, because their strategies have patience. They merely react to changing events, and don’t outstay their welcome. 

The other important consideration of why CTAs have a good record against the bear is that they invest in futures markets that have deep liquidity. That is vital because during bear markets, liquidity is everything. That is unless you truly are a long-term investor.

It’s not over until everything has gone down

I recall a meeting in early 2008 with Anthony Bolton, the well-known fund manager from Fidelity (now retired). He foresaw problems within the banking system, felt the economy was going to slow, but didn’t think the market correction would be over until commodities had fallen. 

At the time, this was something I disagreed with, as I owned commodities in order to protect my portfolios, not to put them at risk. But the great man was right, and in the late summer of 2008, oil collapsed from $140 to under $40, while the rest of the commodity market collapsed around it. 

This wasn’t a rerun of the 1970s, as I had previously thought, but a deflation shock. I did what I had to do and exited my non-gold commodity positions. While earlier than most, I would have been earlier had I listened. The lesson learnt is that it’s not over until everything has gone down. 

He didn’t predict the collapse in commodity prices. He merely stated that he believed that everything must fall. In other words, in his eyes, there is no such thing as a safe haven. To clarify that, he mainly invested in growth stocks and was content to lose money during bear markets, in the knowledge that his losses would be temporary. 

He didn’t believe it was practical to sell all his companies, because he couldn’t time the market. At least, he probably knew a great deal about market timing, but when you manage billions of pounds in small and mid-sized companies, you have no choice but to remain committed. After all, the best fund managers know that the good stuff will bounce when the bear ends.

The importance of liquidity

Bolton felt there were no havens in his world of growth-orientated mid and small caps, not that there were no havens anywhere. He knew that when the bear came, liquidity in his space evaporated, so it paid to own the best companies, rather than the fastest growing, cheapest or most speculative.

The key lesson that I learnt over 2008 was the importance of liquidity. That is the ability to trade, at a fair price, whatever the weather. Liquid assets hold up better than illiquid assets during bear markets and command a premium. Just as blood flees the fingers and toes and retreats to the heart in the cold, liquidity stays close to the most resilient assets such as blue chip stocks, currencies, gold and government bonds: these are all high-quality investments. 

What we have witnessed time and again, is that most speculative investments see liquidity vanish, as the money finds its way into the safe havens. And it happens much more quickly than you expect. 

It is right to assume that speculative investments, or more specifically lower quality investments, will turn sour when the market comes under pressure as liquidity flees. But I recall one exception. The junior gold mining stocks, the sector that reliably manages to disappoint investors even when it wins the lottery, surged in 2002, when the rest of market was under severe pressure. 

That wasn’t unreasonable, as the preceding boom centred around technology, while mining and similar “old economy” areas had been shunned. Given there had been little liquidity or speculation to start with, it stands to reason that there was little to flee. As the fundaments turned in their favour, the miners surged. 

A combination of a rising gold price, after a 20-year bear market, and low valuations, meant that this area of the market was under-owned. Perhaps low-quality sectors can be held provided they have been out of favour in the preceding cycle. Ideas on this are welcome, but I say beware.

Good ideas are dangerous

The gold miners worked in 2002 because they were cheap, and the wind blew their way. Yet other “thematic” investments are normally extremely dangerous during bears as the better the story, the more money you stand to lose. Hype soon turns to despair, and I would suggest that the popular themes from the past bull market should be avoided. 

In today’s market, these include robots, artificial intelligence, cannabis, electric cars, longevity, rare earth metals and even my personal favourite, blockchain. That I am a long-term believer in the merits of blockchain, doesn’t mean the price can’t collapse now. Experience has taught me to be pragmatic and realistic. 

The point is that speculative sectors only go to the moon, when there is excess liquidity sloshing about in the financial system. When the liquidity evaporates, successful investment themes must be real – as in profits now, rather than at some point in the future. Dull beats exciting, because the bear prize goes not to the ones who made the most money, but those who held on to what they had. Exciting investment themes ranging from cannabis to robots are doomed to failure. That’s not because the underlying industries are irrelevant, but because the prices can get way ahead of reality.

Recall that in 2007, there was a boom in alternative energy in response to a surging oil price. Yet in 2008, the WilderHill Clean Energy Index fell by 70%, with most of that loss occurring over 57 trading days. The problem here was not just the speculative nature of the companies, and the high valuations, but the absence of liquidity that followed when the music stopped. It didn’t take much selling pressure to annihilate the price. And for the record, that index is still 62% below the 2007 high. 

Next time, you can bet that cannabis stocks will join the 90% club (as in losses). I know that because the only people that have mentioned cannabis stocks to me are people on my dopey list. I keep in touch, because if nothing else, they are useful contra-market indicators. I know cannabis will crash, because great investments are rare and weeds are plentiful.

Closed-ended funds

Closed-ended companies, such as investment trusts, inevitably have compelling long-term strategies, but they can become a nightmare during the bear. That’s especially true if the underlying assets are illiquid such as property, private equity or infrastructure. The equity investment trusts are at risk of slipping to a modest discount to underlying net asset value (NAV) per share, say 10% to 20%, but that loss will be temporary as the discount will close when the bear finally ends. 

But those less liquid strategies, such as peer-to-peer lending, aircraft leasing and many other exotics, are at risk of sliding to a much larger discount than the equity funds. And for that reason, you should be prepared. 

The closed-ended funds most at risk will depend on the nature of the bear market. If inflation stays low, and they pay an income stream, they may hold up well. But if inflation rises, such as in the 1970s, then expect trouble.

Keeping it real

I want to close on something that is important. The current generation of investors have never seen a bear market that has been driven by inflation. Every shock since the 1980s, has been deflationary. Government bonds have kept you out of trouble. But can we be sure this will always be the case? I very much doubt it. 

Looking at the price of the S&P 500 having stripped away inflation over the years, tells much about our history. Firstly, the “trend” rate of return for equities has been inflation + 2.6% + dividends, per annum over the past 70 years. The post 1949 period was spectacular, but it ended abruptly in 1968. The next 14 years saw a 65% real decline in the stock market, ending in 1982. The subsequent surge from 1982 to 2000 was the best on record.