FINANCIAL SENSE: Making bear markets bearable By Darrell J. Canby/Local columnist November 24, 2008 For the average investor, bear markets can be hard to bear. Watching your investments shrink in value can be humbling, frustrating and even frightening. Those near retirement may suddenly see a need to continue working or to adjust their spending habits. Those already retired may wonder how they will survive. Yet, for those who invest, bear markets are a necessary burden. Like taxes, elections and Monday mornings, they are unavoidable. A bear market is a period during which the value of the S&P 500, an index of stocks that represents the domestic markets and includes the average performance of 500 widely held common stocks, falls by 20 percent or more over a period of at least two months. Bear markets are characterized by a lack of investor confidence. As prices fall, investors sell their stock, which causes prices to fall more and the bear market becomes self-sustaining. As the volume of stocks being sold increases and demand for them decreases, prices drop, as supply exceeds demand. Even if a stock is fundamentally sound, its price will likely drop. Adding to the selling pressure, many financial organizations have experienced redemption requests from their investors. In order to meet those obligations, these organizations have needed to sell stocks to raise the cash required. The volume of these redemption requests could cause the institutions to sell assets, no matter what the price. Investors are already seeing their second bear market of the millennium. During the last bear market, which lasted from March through November 2001, the S&P 500 lost nearly half of its value, dropping 49 percent, according to Standard & Poor statistics. With the subprime mortgage crisis as a catalyst, the current bear market is even worse and is setting records as the country goes through its most difficult financial crisis since the Great Depression. The S&P 500 dropped a record 106.85 points, or 8.81 percent, on Sept. 29, 2008 and on Oct. 7, 2008 closed below 1,000 for the first time since 2003. The S&P 500 enjoyed its largest point gain ever on Oct. 13, adding 104.13 points, or 11.58 percent, then dropped 9 percent on Oct. 15. The frequency and magnitude of the highs and lows, even during a day, has sent volatility indices to unprecedented levels. History of Bear Markets While no two bear markets are alike, an understanding of past bear markets can be instructive about what to expect in the current market. We also should reflect upon the phrase that is often used in periods of extremes, which is “this time it’s different”. The most recent example of the “this time it’s different” fallacy was in the late 90’s into the early part of the millennium. Historically this period is referred to as the “dot come bubble”. The economy was riding high, with unemployment low and the stock markets soaring, especially for technology stocks. We had companies growing rapidly but many within the internet business were not generating sufficient revenues to meet operating expenses. The rationalization was that we were in the “new economy” and this time it was different. The bubble burst in March, 2000 as the market corrected to a lower level. Fundamental investment principles suggest that earnings drive stock valuations. Good companies make profits and these earnings support the price of that company’s stock. Emotions had driven the markets to new levels, but fundamentals brought the markets back to reality. Any review of bear markets typically begins with the Great Crash of 1929, during which the stock market lost 86 percent of its value over a 33 month bear market. However, in the five years before the Crash, the Dow Jones Industrial Average increased nearly fivefold. The Crash, which damaged consumer confidence and led to lower consumer spending, was one cause of The Great Depression, but it was not the only cause. Historians generally agree, for example, that The Smoot-Hawley Tariff Act, which raised tariffs on more than 20,000 imported goods, was also a key cause. Other countries retaliated and trade slowed significantly as a result. Leading up to the Great Depression, many Americans were so taken up with the stock market boom, they borrowed money to buy more stock. As a result, the market crash created a credit crisis for the banking industry. As consumers lost confidence in their banks, they began to take their money out. When consumers started withdrawing their money, others joined in, creating a run on many banks. The initial bear market ended in June 1932, but additional bear markets took place in July 1933, March 1937 and November 1938. None was anywhere near as severe as the initial crash, but the market did not recover until World War II stimulated the economy. While some may see parallels to today’s financial crisis, there are also major differences. As during the Great Depression, banks have made risky loans and, in some cases, have become bankrupt or severely damaged. Confidence in the financial systems waned both during the 1930’s and now. This time the government intervened and took steps in an attempt to prevent the financial systems from faltering further. These steps are designed to restore confidence and allow banks to start lending. The federal government’s decision to increase the limit for insuring bank deposits from $100,000 to $250,000 per account and to use $700 billion to promote stability in the financial systems are two examples of these steps. th We’re now in our 15 bear market since the Great Depression. Some have been relatively short, such as the four-month drop from August to December 1987, which included a seemingly devastating 500 point drop in the Dow Jones Industrial Average. However, that bear was overrun by a long-lasting bull market that quickly made up the market losses. Other bear markets have lasted nearly two years, such as the bear market that took place from January 1973 to October 1974. In terms of impact, that bear stripped the S&P 500 of more than 48 percent of its value. Similarly, during the current bear market, the Dow Jones Industrial Average and the S&P 500 have both dropped more than 40 percent from their peaks. What To Expect The good news about bear markets is that they historically have been followed by bull markets, during which stock prices surge. A bull market is the opposite of a bear market; investors overreact to either extreme, but in a bull market they typically seek to hold and buy more stock to take advantage of surging prices. The result, likewise, sends prices higher, causing the bull market to sustain itself. Historically, gains from bull markets have exceeded losses from bear markets. Unfortunately, many average investors panic and pull their money from the market during a bear market. As a result, they suffer from bear market losses, but fail to benefit from the bull market gains that typically follow. Few investors recognize bear markets as a buying opportunity, even though bear markets result in stocks selling at bargain prices relative to their historic highs. The current stock market is like the housing market – the stocks and the companies they represent may still be the same, but they are selling at a far lower price. It is a “buyer’s market,” but many buyers are holding out. Some may be waiting with the hope of buying when the market is at its lowest point, but no one can predict when that will be; hopefully, we’ve already seen it. Others are too shell shocked and, reflecting the general mood of the market, will wait until prices rise before they buy again. The current situation could play out like the 70’s or the 90’s depending upon the time it will take for trust to be restored in the financial systems and consumers becoming more confident in the system and the safety of their jobs. The decade of the 70’s brought us the energy crisis, double digit inflation and a stagnant economy for a prolonged period. The recession of the early 90’s was painful, but not nearly as deep nor as long as that of 20 years earlier. Emotions and attitudes are playing a major role in today’s markets and will also be paramount in defining the length and depth of the current recessionary environment. Eventually the markets will revert to fundamental principles, but that may take some time. Darrell J. Canby, CPA, CFP is President of Canby Financial Advisors, LLC, a Registered Investment Adviser, located at 161 Worcester Road, Suite 408, Framingham, MA. He offers securities as a Registered Representative of Commonwealth Financial Network, Member FINRA/SIPC. He can be reached at 508-598-1082 or firstname.lastname@example.org.