Preparing For the Next Bear Market in Stocks

Another bear market in stocks will occur.

When? We do not know. Yet, we are preparing for it.

If you are curious why and how we are preparing for the next bear market in stocks, continue reading.

Why we are preparing for the next bear market in stocks

A bear market is defined as a stock market decrease of 20% or more. On average, bear markets occur about every six years.

The stock market is at an all-time high. So, the next bear market in stocks is around the corner, right? Not necessarily.

A recent report from JP Morgan looks back over the past 30 years in the stock market to show how investing at all-time highs does not necessarily mean stocks will crash.

Source: JP Morgan

There are numerous reasons stocks could continue to grow, including loose monetary policy from the Federal Reserve and economic rejuvenation post-Covid.

It is worth noting, not every stock market decline has to be cataclysmic. In fact, smaller declines, not classified as a bear market, occur frequently. Capital Group shows how smaller declines do not always turn into a feared bear market.

A recent history of bear markets

In 2020, the Covid-induced bear market was fast and deep, resulting in stocks declining 34% in a month.

With people generally concerned more with health and the swiftness of the decline and subsequent recovery, it did not leave as much room for investment panic.

Stocks began a recovery on March 23, 2020 amid the release of terrible unemployment numbers.

2020 bear market
Source: Koyfin. SPY from 02/18/2020 to 03/23/2020

In 2008, the bear market in stocks was drawn out to 17 months. A year and a half of declines wore many investors down.

Due to a collapse in mortgage loans, and coupled with a crash in real estate values, the danger of the financial system collapsing was a stressful thought to investors.

Source: Koyfin. SPY from 10/09/2007 to 03/09/2009

 

In 2000, the bursting of the technology sector bubble caused a multi-year drawdown. Speculation was punished and diversification was rewarded as the bear hit areas of the market much worse than others. As you will see below, the tech heavy Nasdaq (QQQ) experienced the greatest drawdown.

Source: Koyfin. SPY, DIA, and QQQ from 03/24/2000 to 10/09/2002

Each bear market is different in cause, length, severity, and response. Trying to outguess the next decline is fruitless except to be prepared by sound investment principles.

Because we do not know when the next market decline will occur or what will cause it, we are already prepared.

How we are preparing for the next bear market in stocks

The nitty gritty of how we prepare for the next bear market is unique for each client and their exact situation. However, there are general, time tested principals we utilize to increase chances for investment success.

Asset Allocation:

Most investment plans should target an allocation of stocks vs. bonds.

Stocks can act as the long-term growth engine (inherent with fluctuation).

Bonds can serve as a ballast of stability. While bonds can decrease in value, they generally operate in a tighter return range, neither falling nor rising as widely as stocks.

For a Retiree: The amount you have in bonds should be enough to cover at least several years of income. If (and when) stocks decline significantly, bonds can provide the income needed thus preventing the need to sell stocks at a significant discount. In other words, do not be forced to sell stocks at a loss.

For the growth investor: Bonds can serve to temper the decline of a stock pullback and allow rebalancing into stocks while they are discounted.

The allocation of stocks vs. bonds (how much of each) is a unique decision based on your income need and risk tolerance.

Bond characteristics:

For bond exposure, we target high quality and short duration. These characteristics accentuate the reason for holdings bonds in the first place:

  • More stability
  • Less alignment with stocks

Anthony Saffer, CFP® wrote recently about, “Are Bonds Worth Investing In?”

Tactical risk management:

Having a tactical component is designed to manage risk, seeking to provide exposure to risky assets while decreasing the likelihood of incurring a large drawdown.

Using a systematic process, the tactical portfolio actively shifts between an offensive and defensive composition.

A tactical strategy, otherwise known as trend investing, is not intended to guard against minor corrections, but more likely to minimize larger bear market drawdowns.

Cash reserve:

Low interest rates and higher inflation mean cash in the bank is losing real value. Yet, having a cash reserve still makes sense because of stability for near-term needs and the convenience of quick access.

During a bear market in stocks, having a cushion of cash reserves can make you a better investor by preventing panic and awaiting recovery. As Alex Okugawa, CFP® wrote, a cash reserve can help alleviate stress and worry.

Conclusion

Preparation for the next bear market in stocks, requires an investment plan that aligns with one’s personal financial plan.

It may sound appealing to try to time the stock market, but it does not work with any consistency. Mistiming the downside or the subsequent upside can cause severe damage to an investment portfolio.

Preparing for the next bear market in stocks begins when times are good.