Air Line Pilot, June/July 2001, p.30
By Robert D. Lipsey, CFA

A cynic once noted that the stock market seems to do whatever is necessary to prove the majority of investors wrong. This observation, I believe, will be essentially accurate as long as economic forces that are cyclical in nature continue to drive the markets.

And this notion is not as perverse as it might seem. When times are good, the market discounts good times—it becomes expensive. When times turn difficult, the market gets cheap. And, because booms lead to busts (and vice versa), the market itself is not very good at telling investors when to jump in with both feet and when to keep well away from it.

So, what strategy makes the most sense during bear markets? Nearly any investor—who is lucid—knows from the start that the stock market does not go up in a straight line forever. Negative markets can be expected to take place periodically, and they can involve significant losses. However, dealing with a future eventuality is one thing, and actually watching retirement assets appear to evaporate into thin air is quite another. And, for those of us who consider ourselves to be in charge of our own destinies, a powerful urge arises to do something—maybe anything.

Various approaches often come to light either intuitively or as a result of the suggestions of others. These approaches often incorporate some combination of the following elements:

• Sell stocks to raise cash immediately.

• Try to determine some sense of what pattern the bear market might take, through historic experience with such markets and the economic circumstances that led to them.

• Keep on top of the numbers that are regularly reported with regard to economic activity.

• Get back in when things seem better, with the understanding that a bell doesn’t ring at market bottoms.

The problem is that each of these elements contains so much inherent uncertainty that their application involves a better-than-even chance of causing more harm than good.

Selling stocks to raise cash works fine—if it is done before the market turns down. Usually, however, even severe bear markets (those associated with deep recessions) are not apparent before a great deal of the damage already has been done. Conversely, to make matters worse, even sharp dips can signify nothing more than short-term corrections. Remember that in October 1987, the market lost more than 20 percent of its value in a single day. The economy, meanwhile, continued to grow—and the market followed shortly thereafter.

Bear market patterns are equally problematic. Reviewing historical experience and determining ranges and averages with respect to lengths and magnitudes of these declines is easy enough, of course. The lack of central tendency, however, makes it quite unlikely that any particular experience will coincide with the averages, and in fact, there is no particular reason to believe that historic ranges will provide best- and worst-case boundaries for the future.

Because periods of negative growth in economic activity are almost always associated with bear markets, listening to economic releases is a very popular exercise among professional investment managers and amateurs alike.

The problem is that the market is a leading indicator. Market peaks lead peaks in economic activity by nearly half a year on average. Often by the time concrete evidence of a recession is apparent, most of the damage to the market already has been done. Having an economist as an investment advisor is a little like having a pathologist as a personal physician. They both know a lot, but it’s at least one day too late.

What about economic forecasts? As it turns out, the best forecast of the future usually is the present. Most economists, indeed, extrapolate current trends to try to determine what will happen next. And the truth is, that exercise generally works well, except at those times it is needed the most—at inflection points.

Pundits say that to time the market successfully, one must "be right twice." Getting out of a bear market does no good unless one can get back in before the market passes one by on the way back up. And timing reentry is no easy task. Markets reach their bottoms when the majority of investors become convinced that the only glimmer at the end of the tunnel is the headlight of an oncoming train. I can recall that at the end of the 1973–74 bear market (when the S&P lost nearly 50 percent from its peak), many professional investors were expecting another 50 percent decline. And, like market peaks, market troughs lead the economy by nearly half a year, and a very significant portion of a bull market’s return often takes place in the first few months of its emergence.

Provided that one has a well-diversified portfolio, with an asset mix that was developed with the understanding that negative markets would occur from time to time, the best course of action usually is to take no action at all, except to rebalance. Furthermore, while at the time raising cash in a bear market may feel like the safest thing to do—it can be very dangerous. The problem lies in the fact that investment returns are a function of cash flow as well as of securities price movement.

Positive cash flow in various market environments is commonly known as dollar-cost averaging. When markets are down, cheaper securities are purchased, leading to enhanced future returns (when markets are up, of course, the opposite effect occurs, but no one seems to care). During periods of negative cash flow, the experience is reversed.

The tables on page 31 developed by T. Rowe Price Associates illustrate this point. The tables depict two different scenarios for the account balance of a retiree who

• begins with a sum of $1,000,000 at the beginning of 1968,

• invests in a portfolio of 60 percent stock, 30 percent bonds, and 10 percent cash, and

• withdraws an amount equal to 8 percent of the initial sum each year thereafter growing at 3 percent per year.

The table on the left depicts what would have happened to the retiree’s portfolio given the actual returns provided by the hypothetical portfolio. The retiree runs out of cash by 1982. The table on the right shows what would have happened had the retiree experienced the same returns as the 1968–1998 period—except in reverse order. In this case, the retiree has enough to withdraw his or her target each year for 30 plus years and winds up with a balance of $6,292,380. The average return for the two scenarios is the same—only the sequence is different. The reason for the difference in returns is that the portfolio had to sell at depressed prices during the 1973–1974 bear market and thus was never able to take advantage of the subsequent recovery.

The tables were designed primarily to demonstrate the dangers of relying on averages, but they illustrate equally well the dangers of selling during bear markets. And, the market doesn’t care whether stocks are being sold to provide retirement income or to reallocate into a money market fund. The effect is the same, and in the wrong sort of market, selling low can have catastrophic results.

So what to do when markets decline? Given the uncertainties involved—in raising cash, in trying to take advantage of bear market patterns, in making good use of economic statistics, and finally, in getting back into the market on time—the best course of action is probably to take no action at all.

The optimal solution to the bear market dilemma is to prepare before the problem occurs. Make sure that portfolios are well diversified and adequately allocated to assets whose returns are not positively correlated to the stock market and economic activity, depending on the portfolio holder’s age and circumstances. This prior solution is of crucial importance. Selling stocks in a bear market can be a very risky thing to do.

Source: T. Rowe Price