In this guide, we look at what bear markets are, why they happen and how best to invest when the markets take a turn for the worst.

After the boom, here comes the bust?

2021 was a year unlike any other. Asset prices rose across the board. Tech stocks, green-economy stocks, cryptos, small-cap ‘stonks’, MEME stocks, SPAC, property – you name it. In fact, the more speculative the asset, the bigger the boom. Never before has so much money been created by the Federal Reserve. That lifted boats of all sizes.

But that was then. The last six weeks, however, saw the return of fear.

In particular, investors worried that the Federal Reserve is on the cusp of raising rates aggressively. The March rate hike is now expected to be 50 basis points (0.5 percent). This could be the first 50bps hike in years. Oh, a take-the-punchbowl-away Fed is such a party pooper!

Growth stocks collapsed as investors fled into safe-havens and defensive sectors. The riskier the asset, the steeper the decline. A few weeks back, I wrote about these rotations in GMG (see ‘Six Market Trends to Watch in 2022‘).

To give readers some examples of the staggering scale of wealth destruction in the past two quarters. RobinHood (HOOD) slumped from $84 to $13 (-88%), Rivian (RIVN) plunged from $170 to $60 (-65%); Paypal (PYPL) collapsed from $310 to $115 (-62%); even Netflix (NFLX) dived from $680 to $400 (-40%).

When the largest tech stocks like Meta (formerly Facebook) start to roll over, you know the party is probably over.

 

What is a bear market?

A bear market is a general term that describes falling prices over a period of time. Some market commentators stick to the definition that when major stock indices have fallen 20% from their highs, it signals that a bear market has commenced.

Like night follows day, a bear market often follows from a bull market. This is to eliminate the excesses accumulated during the bull market. The last bear market we saw was in March 2020 when the pandemic took hold. But are we in a bear market now?

Today in the U.S. we are in the fourth super bubble of the last hundred years.” declared market expert Jeremy Grantham in his widely-read market letter, entitled “Let the Wild Rumpus Begin“.

The most important and hardest to define quality of a late-stage bubble is in the touchy-feely characteristic of crazy investor behavior. But in the last two and a half years there can surely be no doubt that we have seen crazy investor behavior in spades – more even than in 2000 – especially in meme stocks and in EV-related stocks, in cryptocurrencies, and in NFTs.

After seeing a late-stage massive blowoff last year (see below), he concluded that “this checklist for a superbubble running through its phases is now complete and the wild rumpus can begin at any time.”

Source: GMO

Market volatility is spiking; bond prices falling; value tech stocks outperforming, and gold prices bouncing – all hallmarks of a potential bear market.

That said, many will argue that he could be wrong. Look at the S&P 500 Index, it is still holding firm near its all-time highs despite the recent wobble. Not to forget is that an equity bear market is often precipitated (or accompanied) by an economic recession. Last month, the IMF estimated that the world economy will grow by 4.4% this year. Company earnings are steady in many companies (e.g., Amazon and Apple). So many investors are not entirely convinced (yet) that we are doomed for a “hard landing”.

Even if Grantham is wrong, the reward for buying risk now may not be ideal – given the list of growing macro ‘worry’ factors sapping market confidence.

Factors such as surging inflation, hawkish central banks, rising energy prices and most recently, the threat of war in Europe. Gone are the days when investors can ignore risks altogether and still make handsome returns.

Verdict:  Inflation is here to stay, at least for the time being. This will incur growing pressure on central banks to curtail quantitative easing and raise interest rates. When this happens, equity markets will need to adjust, probably to the downside. It is often said that bull markets don’t die of old age, rather they are assassinated by central banks. This is still true. Whether we like it or not, markets are cyclical. We will play the hands we are dealt with right now.

Four strategies to survive an equity bear market

1. Overweight cash (and wait for opportunities)

One of the most undervalued assets during a booming market is cash. Who wants to hold cash when asset prices are leaping? What is missing in this logic is that markets can turn around quickly and trap investors who bought at high prices. You don’t see Buffett going ‘all in’ with their cash holdings. Last year, Berkshire Hathaway (BRK.A) held $149 billion in cash.

In a bear market, cash is king. It gives investors the most flexibility in buying stocks at the most favourable prices. This lays the foundation of bagging a fortune in the ensuing upswing. As the saying goes, “you make most of your money in a bear market; you just don’t realize it at the time.” (S. Davis)

2. Trade (very) oversold conditions

During a bear market, prices can plunge suddenly and overshoot to the downside – due to a cascade of bearish catalysts. In these instances, you can trade the depressed sentiment by buying sound companies that are temporarily oversold.

However, because you will never know in advance whether the bear market has ended, so scaled in gently with an appropriate position size relative to your portfolio and utilise stop losses. Once prices move advantageously, take the profit and don’t be greedy. Wait for the next opportunity. Enforce some trading discipline.

Bear market rallies can occur once or twice in a year. Depending on sectors, some stocks can bounce 25-100%.

3. ‘Know what you own and why you own it’ – P. Lynch

The bear market will likely annihilate the most vulnerable companies – companies with no viable income, market share, or products. They will suffer during a recession, however mild. Knowing a sector inside out becomes an edge. This edge differs from person to person. One might be an expert in online retail sector; the other auto industry. Having an edge gives investors the courage to hold a stock during a market setback.

Companies most likely survive a recession are strong companies with a sticky ecosystem, with good product streams. These companies often rebound the fastest due to investor accumulation.

Once you know a company thoroughly and have faith in its long-term prospect, buy on setbacks and wait patiently for the better times to return.

4. Look for new leaders

Every cycle brings out new stock leaders. For example, many high-flying Nifty-Fifty stocks collapsed during the 1974 bear market and never recovered. Many dot-com stocks surged in the late nineties, but by 2002 many were gone.

The seeds of the next bull market are sowed during a bear market. The key question is: How do we detect new cycle leaders? Relative strength (see GMG Guide on Relative Strength). This measures the price of the stock relative to the price of the market, say, the FTSE 100 Index. Stocks that exhibit good relative means it is outperforming the market – and market leaders outperform the market.

Remember Tesla’s (TSLA) stunning advance in 2020 when the world was still mired in the pandemic? That’s relative strength. Tesla’s share prices broke new all-time highs in June 2020 and then promptly rose 5x in six months!

To differentiate your portfolio from the rest, always look for potential new leaders in the next bull market.

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