Taming expectations in a bear market

Written: 15 July 2022

Author: Kirsty O’Hara

5 min read

The talk in investment land recently, has been all about bear markets. What are they? How long do they last? Should we be scared? And how do emotions further rock the investor ride?

If you’re new to investing or haven’t encountered a bear market before in your investor journey, then we’ve attempted to highlight the best points for consideration when navigating the current bearish climate.

What’s a bear market?

Bear markets are commonly associated with prolonged investor pessimism and negative sentiment.

A bear market should not be confused with a correction, which is a short-term trend that has a duration of fewer than two months.

Andrew Bascand of Harbour Asset Management explains that "a bear market is when we see a sustained fall in equities of 20%”, and he notes that we were down 24% on June 19^th from the market peak observed on January 3^rd 2022.

Officially we enter a bear market when the stock prices of equities drop 20% in value. They can be cyclical or longer term; and can last from weeks, to months, to years in duration (let’s hope it’s not the latter).

Investopedia points out that ‘bear markets are often associated with declines in an overall market or index like the S&P 500, but individual securities or commodities can also be considered to be in a bear market if they experience a decline of 20% or more over a sustained period of time. Bear markets may be contrasted with upward-trending bull markets.’

A bull market (by comparison) is when investor confidence is optimistic and linked to expectations that prices will rise. Most commonly a bull market is characterised as a period where stocks rise by 20% after having declined previously.

Why do they call it a bear market?

The origin of the title ‘bear market’ is a topic of healthy debate.

Numerous financial commentators, including Investopedia, cite the idea that: a bear swipes it’s paws downwards, dragging things down with it. A bull market in comparison is linked with the symbology that a bull can attack with its horns, and hook things in an upwards thrusting motion.

Andrew Bascand of Harbour Asset Management comments that “often a bear will come charging out of nowhere, and for many investors that is what a bear market can feel like”, however he also speaks to the definition cited by Merriam Webster where a 16th-century proverb is the source, saying: “It’s unwise to sell a bear’s skin before catching it.”

For the history enthusiasts amongst us, Merriam Webster offer up the following story, in relation to short sell trading, as the catalyst for this ancient proverb gaining traction during times of bearish market activity:

‘The bear sold a borrowed stock with a delivery date specified in the future. This was done with the expectation that stock prices would go down and the stock could be bought back at the lower price, with the difference from the selling price kept as profit. This type of selling was used by many people involved in an early eighteenth-century scandal in England known as the South Sea Bubble.

The South Sea Bubble gets its name from the South Sea Company, founded in 1711 to trade with Spain's colonies in the New World. South Sea stock became highly desirable when the king became governor of the company, and soon stockholders were enjoying returns of up to 100 percent. In 1720, the company assumed most of the British national debt and convinced its investors to give up state annuities for company stock, which was sold at a very high premium. Many of the speculators were selling stock they did not own, and when the stock price suddenly collapsed, the result was a debacle for the company and a tragedy for many investors. The term bear had been in use prior to the breaking of the South Sea Bubble; however, the affair brought bear into widespread use.’

What causes a bear market?

According to Investopedia: “Stock prices generally reflect future expectations of cash flows and profits from companies. As growth prospects wane, and expectations are dashed, prices of stocks can decline. Herd behaviour, fear, and a rush to protect downside losses can lead to prolonged periods of depressed asset prices.”

Unless you’ve been living under a rock, it’s hard not to take notice of herd antics. As the herd panics, the herd sells, and the value in the stock drops. More of the herd notice the decline, and they sell too, creating a snowball of behaviour that can add to the public perception that markets are falling.

The motivation behind this current herd behaviour is easy to comprehend, with Robin Powell of The Evidenced Based Investor summarising the current economic climate as a perfect storm of key monetary drivers, stating:

“The upsurge in inflation is due to a combination of factors. Global supply chains were disrupted by the pandemic at the same time as central banks and governments were pumping up demand through monetary and fiscal stimulus. Disruption to supply alongside the supercharging of demand was a sure-fire recipe for inflation.”

On top of inflationary consequences linked with the Covid-19 pandemic, Robin acknowledges the following factors as bear market drivers:

Policy responses to Russia’s invasion of the Ukraine have consequently put a rocket under oil, gas and food commodities.
Reverse course behaviour from banks on interest rates and bond buying programs, is raising questions around the affordability of financing debt; and also generating questionable bond yields (which normally provide a safe haven for investors).
Climate change is driving a heavy focus on humans rethinking the energy sector.
Concern that central banks will accelerate and overdo the reversal of stimulus propping up the global economy.

With everyone scrambling to get their heads around inflation, after a period of ‘cheap money’ it’s no wonder that forecasting the impact of interest rate rises, across consumer and business cashflow, is top of mind for a lot of investors and fund managers now attempting to de-risk their portfolios.

Economics professor, Vidhura S Tennekoon, addresses this emotional rollercoaster by stating: “entering a bear market can have a psychological impact on investors, creating a self-fulfilling cycle. Perceiving a bear market tends to prompt investors to sell even more, thus pushing prices down further and prolonging the pain”.

An astute investor will likely remind themselves that current stock prices reflect not only this herd sell-off, but also acknowledge that stocks are priced base on expected forecasted returns of a company - and therefore would expect the current prices to be a reflection of market expectations.

How long do bear markets Last?

The good news, is that bear markets don’t last forever. They are a normal part of investment cycles.

The Economist’s editorial finance team reassuringly suggest that historically a Bear Market tends to last up to nine months. Given the current bear market is already 6 months along this trajectory, having officially begun on January 3^rd 2022, we collectively hope the Economist are ‘on the money’ with this nine month trajectory.

While no one knows for sure when a bear market will end, what we can take from this is the hopeful understanding that we might (if we’re lucky) be past halfway – which for some investors can be immensely reassuring.

If you prefer to consider ‘worst case scenarios’ you may like to consider the three most drawn out bear markets as doomsday benchmarks:

The financial crisis of the 2007-2009 GFC: played out over seventeen months.
The Dotcom bubble: from peak to trough lasted two and a half years.
The 1929 crash: took nearly three years to run its course.

Does a bear market mean we should expect a recession?

Without a crystal ball, it’s hard to say. A bear market may signal a recession is coming, though it’s not a perfect correlation.

Investopedia calculate: Of the 25 bear markets since 1928, 14 have overlapped with recessions. These bear markets ranged from one month to 1.7 years in length; and varied in severity from 20.6% to 51.9%, according to an analysis by First Trust Advisers based on data from Bloomberg.

When thinking about the collective good of the economy in general, Andrew Bascand suggests that the interest rate hikes that we are currently seeing, are normal in an economy where governments need to slow the rate of inflation and use interest rates to do so. While interest rate hikes can create reduced investor confidence, they also can provide a more stable economy compared with times experienced in the 1970’s when governments were too slow to introduce tighter monetary policy and as a result an era of stagflation occurred.

Financial Times Asset Management reporter, Chris Flood, comments: “Investors may brace themselves for more volatility on the stock market until they are satisfied that the Fed has regained control over inflation — currently running at a 40-year high of 8.6 per cent”.

Should I feel scared?

To bolster investor confidence when buying funds in a bear market, David Boyle of Mint Asset Management likes to remind investors of the baked bean theory:

“You go to the supermarket and buy the same can of baked beans week after week. One week the can might be cheaper. At the supermarket, a shopper's instinct is to buy more and make the most of that cheaper price. "But the psychology of investing is to get rid of it now because we don't want to lose any more money."

Thinking of your managed fund investments like a giant stockpile of cheaper baked beans can be a useful philosophy to follow, if you believe that stockpiling may help you benefit in the future when unit prices go back up again.

Boyle reminds us that “Those assets haven't changed, they're the same good assets the manager has always been invested in. They've just been given a bit of a discount."

What are the key takeaways?

Murray Harris from Milford Asset Management comments: “Even with this year's sell off the market is only back to mid-2020 levels after a 10-year plus bull run. Investors should not panic, stay the course, remain focused on the long term, money in shares should be long-term money”. Harris elaborates that it’s worth remembering “your contributions during a falling market are buying you more value, which you'll benefit from when the market recovers - which it always does.”

Ben Caslon CFA echoes a similar sentiment in his book, stating: “Over decade-long time horizons, your investment performance will mainly be derived from how you handle corrections, bear markets, and market crashes. During every single bear market there will be times when you wonder if the losses will ever stop. You will always wonder how much lower the market can go. The economic news will be terrible. Other investors around you will be depressed. Pessimism becomes pervasive.”

And while both of these sentiments hold true for investors with time up their sleeve, we do observe caution from Vidhura who highlights: “The impact is particularly hard on recent retirees, who are seeing their nest eggs shrink just as they need to start withdrawing income from them”. Without a shadow of doubt anyone wanting to live off their retirement, in the immediate future, will be finding the uncertainty factor of the current bear market and inflationary pressures most concerning.

Managed Funds vs Shares : what’s best for bears?

This is a question, best answered with questions:

Do you have the time (or the desire) to follow and track the markets, to ensure you maintain a diversified investment portfolio over time?
Do you have the means to invest across sectors in individual equities; or would a managed fund that already provides some diversification across multiple companies and sectors provide a greater sense of comfort?
Do you have the personality to hold tight and stick to an investment plan? When you select shares, you need to feel confident in the companies you are investing in; whereas when you invest in managed funds you need to feel confident in the ethos and investment methodologies of the fund manager, and trust the way that they will construct a portfolio to include a degree of diversification.
What’s your risk tolerance? If you know you’re going to be tempted to sell individual shares when they dip, then maybe a managed fund might provide more peace of mind - knowing a fund manager has selected investments as part of a considered strategic framework.

Final thoughts

If you can shift your perspective, and focus on potential gains rather than losses, then bear markets can be great opportunities to pick up some great investments at lower unit prices. Without a doubt it can be scary, but it has been proven before that the market will bounce back eventually.

Ben Caslon (CFA) champions this ethos, stating: “The point is not to predict every bear market or crash, but to psychologically prepare for them ahead of time. Knowing this event can and will occur is half the battle because you will set up your investment plan to take it into consideration. The long term is inclusive of market losses. Prepare yourself and act accordingly.”

Ben also states: “It’s no fun to live through a bear market but we’re already in it. The good news is bone-crushing losses are often a precursor to wonderful returns in the future”.

Happy investing!

Flint

Ps. If you just want to stay calm, and carry on – then we wrote a blog with 7 tips to Stay Calm in Uncertain Times, that you may like to also read.

IMPORTANT NOTICE AND DISCLAIMER:

All content shared is of a general nature, current to the time it was penned, and is not financial advice. Before making any investment decisions, please be sure you have completed full due diligence. This should include reading the product disclosure statement (PDS), considering fees and taxation, identifying your time horizons, and understanding the performance history and reputation of the investments you are considering.

Please note: When investing you are not guaranteed to make money (and on occasion you may lose some or all of the money you began with). Seek independent advice to establish if an investment is suitable for your financial situation and long-term wealth generation goals.