Keys to Investing in a Secular Bear Cycle

Over the past several postings, I discussed secular investment cycles and how valuations and volatility influence these cycles. The broad based domestic stock market has been mired in a secular bear market since April of 2001. Secular bear cycles produce little or no gain to many investors, but it doesn’t have to be that way. Here are five keys to investing in this type of environment.

1.) Invest Against Gut Instinct: The average investor has inflicted far more damage to their portfolio than the market has. On an annual basis the research firm Dalbar does a study that compares investor’s earnings to the average investment using the Standard and Poors (S&P 500) as a proxy. Over the past twenty years ending in 2010, the average equity fund investor made 3.83% while the (S&P 500) Index made 9.14%. Why the difference? It’s because people tend to buy and sell in extremes at the very worst time, systematically selling their losers to buy yesterday’s winners when they should be doing the exact opposite.

2.) Diversify, Diversify, Diversify: From April 1st, 2000 to the end of 2011, the S&P 500 has made a paltry .37% annually over this time frame. However, the S&P 500 alone is not a diversified portfolio. If you also invested in stocks of smaller companies and emerging markets, commodities, real estate investment trusts and bonds, you would have done a lot better than solely holding large company stocks over this time period.

3.) Employ Tactical Underlay Using Volatility and Valuations: Forward looking returns for an asset class isn’t stagnant in nature; it depends on valuations. If an asset class goes down, you should only expect higher forward looking returns (the opposite can be said if an asset class goes up in value). Below is an illustration of how this works. This graph is courtesy of the Hussman Funds and was part of their Weekly Market Comment on August 29, 2011. This outlines the projected 10-Year S&P 500 Annual Returns based on historical growth rates and the level of the S&P 500 Index. As you see, the further the market drops (horizontal line), the higher the projected rate of return (vertical line). Although the past can’t always predict the future, valuations have provided a good forecast of what to expect.

How can you take advantage of this? Rather than having a set percentage towards each asset class, allow yourself a range and tactically under or over-allocate depending on where valuations lie. For example, you can target 60% towards stocks, but allow yourself to be in a range of 50% to 70%. If stocks are historically undervalued, allocate towards the high end of the range, if stocks are overvalued from a historical perspective then target stocks on the low end of the range. To avoid timing the market, systematically review and make any necessary changes on a set time interval such as quarterly, semi-annually or annually.

4.) Acknowledge How Bad it Can Get: The chart above notes something that all stock investors should be aware of. The range of the S&P 500 in the graph depicts the historical range of valuations based on today’s fundamentals. With secular bear markets, valuations usually fall to a point where they usually end up in the lowest one or two deciles. This would suggest an S&P level of 400-600. Back in March of 2009, we reached the 665 level. Maybe 2009 was the bottom, but if we re-test lows this would be a significant decline from a current S&P 500 of around 1365. If you can not stomach the loss potential, it may be a better time to dial down your risk now while we are in historically high valuation territory than in the middle of turmoil.

5.) Invest According to Your Goals, Not the Market: Everyone has a targeted rate of return needed from their investment strategy to meet their goals. This required rate of return is dependant on the current and projected level of income, expenses, assets and debt. This return need translates into an allocation of investment classes and sub-classes. Unfortunately most people spend little time trying to figure this out – and the best way to do this is through financial planning. Instead most people let the markets dictate their investment strategy, which is relying on something that can’t be controlled. If more investors began investing on their needs rather than the winds of current market conditions, they would be a lot better off in the long run.

If you follow these steps, it will not avoid losses. But what it will do is help mitigate losses, accelerate the recovery in your portfolio and give you a better opportunity to make positive real rates of return over the long haul. For more information on market valuations, I suggest visiting Robert Shiller’s website and the CAPE Research Catalog.

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