In my last newsletter I suggested a recession may have begun in the first quarter of this year. I was wrong. The economy squeezed out a 0.6% annualized growth rate in Q1 ‘08. However, according to Warren Buffet anytime that GDP is less than U.S. population growth, we are in recession. The U.S. population growth rate in 2008 is estimated at 0.88% leaving us with a real economic growth of -0.28%. I think I will go with Mr. Buffet’s definition! Either way, it sure feels like a recession. The stock and real estate markets are both down nearly 20% from their peaks. Even bonds, which are normally a good bet going into a recession are getting hit due to inflationary fears. Recessionary times are generally accompanied by “bear” markets, a term investors refer to when the market declines by 20% or more. The last recession, which started in March of 2001 and lasted about eight months, was primarily due to a bubble in technology related stocks. That recession was accompanied by a bear market, which began in January 2000 and lasted until October 2002. Stocks lost 49% during this time period. However, the real estate market was very strong and helped to offset losses investors had in the equities markets. In addition, bonds rallied as interest rates fell and inflation remained low. This time its different. Both stock and real estate markets are in bear territory, while the credit crunch and inflation issues are causing havoc in the bond market. We may be closer to a 1970s style bear market than the 2001 bear.
The average bear market lasts about 14 months with a drop of 32%. However, averages do not tell us what to expect. One of the largest market drops was during the 70’s oil crisis when the market fell 48%.
In nearly every case, the stock market bottoms well before economic activity bottoms. This is because the stock market provides a signal for future earnings, generally at least six months out.
Fighting the Bear
Should we abandon the picnic basket and give it to the bears? Definitely not. First things first, don’t panic. I searched the web for stories written in late 2002 and early 2003 near the end of the last recession. After three straight years of declines, the US markets were off by nearly 50%. Market commentators were fueling the panic with pessimistic articles about expectations in 2003. Many were predicting 30% market sell offs, while others suggested moving entire portfolios to cash. These are the same folks that coined the term “The New Economy” and helped to fuel the tech bubble. As it turns out, 2003 was one of the best markets on record - up 28.7% including dividends and led by “old economy” stocks. The good news about today’s market is stocks are cheaper in relative terms than at the end of 2002!
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1. Invest for the Long Term
Investing in the stock market is for long-term investors only. Investment horizons should be at least seven years or longer. I cannot predict what the market will do in the next 12 months, but a well balanced equity portfolio should be up at least 9% over the next 7 to 10 years. Why? Because bear market sell offs present terrific buying opportunities for patient investors. When was the last best time to buy equities? In October of 2007 when the market reached the end of it bull market cycle, or in December of 2002 when investing in stocks felt like jumping into a bottomless pit? If you invested in the S&P500 in January of 2003, you would be up an average of 12.8% a year over the next four years. Despite the occasional sell off, the market (S&P 500) on average has increased by 11.9% per year over the last 60 years.
2. Do Not Try to Time the Market
Trying to time market swings is a classic investor mistake during bear markets. It is nearly impossible to predict when the market will rebound. Rebounds are usually swift and erratic. As I said earlier, the average bear market drop is over 30%. However one month after the market bottoms out, the average recovery is 10.6%. After three months, the average recovery is 14.7%; six months after bottom, the average recovery is 23.1%. Finally, investors who held on were rewarded with an average 34.8 percent recovery 12 months following a bear market bottom.
3. Doing Nothing Will Not Work Either
Investment portfolios need to be reviewed periodically. During bear markets, additional scrutiny must be made. Now is the best time to shed poor investments. Not every position will come back to its previous value and some will go to zero. We still have not reached the 2000 NASDAQ peak and may not for several years, and this is because many of the highest fliers never recovered.
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4. Converting to Cash May Be a Mistake
Unless you had the prescience to convert to cash in October of 2007, converting to cash now after a 20% correction may not be the best idea. How will you know when to get back into the market? Inflation rates are currently almost double what you can get in a money market, so in addition to missing a rebound, you will lose real asset value due to inflation.
5. Search for Value
It is markets like these where fortunes are made. Many investments are selling at cheap values due to overall market devaluations rather than specific investment risk. For example, nearly all banks are off 50% from their market peaks. However, not all banks are in bad shape. The current environment will make some folks very rich and others lose fortunes.
6. Rebalance
Steep market drops are the best time to rebalance your portfolio. For example, if you held TIPS or other government bonds in your portfolio, now is a great time to sell off some of your profits and re-invest in other sectors that have been hit hard. This allows you to increase your profits when the market improves.
Certainly, the best time to buy is when something is on sale. At this point, equities are now 20% off. The question is, will there be a bigger sale later? Are they about to go on clearance? The approach here is to buy some on sale, but to maintain some powder for a clearance.
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