Recently, I was watching the Suze Orman show on CNBC when a caller asked: “What is a secular bear market?” Apparently more and more investors are wondering about this, and I’ll use this article to address the topic. More important, I’ll talk about what investment strategies are effective in a secular bear market.

There are no universally accepted rules for defining a secular bear market. But in very general terms, it’s a long time, perhaps 10 to 20 years, characterized by below-average stock market returns. Contrast this with a cyclical bear market, which typically lasts from a few months to a year.

The four most recent cyclical bear markets didn’t last long: three months in 1987, four months in 1990, 10 months in 1994 and two months in 1998. The current bear market has lasted longer than these four combined.

More and more commentators are claiming we are now in the beginning stages of a secular bear market. But in truth, it’s simply too soon to know. The last secular bear market in the United States was from 1966 to 1982. Japan continues to struggle through a severe secular bear market that started in 1990.

Figure 1, showing the performance of the S&P 500 Index from 1929 to 1999, is divided into four time periods: two secular bear markets and two secular bull markets. Note that during the secular bear markets (1929 to 1941 and 1966 to 1981), the annualized returns for the index were significantly lower than its long-term average of 10.6 percent.

The 1966-1981 annualized return of 6.0 percent may not seem so bad in the current stock market climate. But adjusted for inflation, it represents a loss of 0.9 percent per year.

While the protracted length of a secular bear market can be extremely discouraging, those with the fortitude to stick with their investments over the long term have eventually reaped the rewards of their patience. The two secular bull markets shown in this table produced exceptional returns for even longer periods of time.

A secular bear market doesn’t mean stocks go straight down over a long period. Figure 2 shows the Dow Jones Industrial Average and S&P 500 since 1962. Though the period from 1966 to 1981 was a secular bear market, stocks went up and down in many cyclical bull and bear markets. But all the zigging and zagging did not lead to ever-higher stock prices.

Still, the zigs and zags were often prominent enough that nimble investors could take advantage of them.

The stock market is partly a creature of psychology. Near the end of a typical secular bull market, stocks are widely regarded as the best way to get rich. (Does that sound like late 1999?) But near the end of a typical secular bear market, many investors are looking at other asset classes to achieve their financial goals – bonds, real estate, gold and commodities.

Strategies for a secular bear market

The bad news may be the possibility of a new secular bear market. But the good news is that investors can maximize their chances for preservation and growth in such an environment with two strategies: diversification and timing.

Because investors can’t see very well into the future, there’s simply no substitute for proper asset diversification. That means having significant exposure to international stocks as well as U.S. stocks, to small-cap stocks as well as large-cap ones and to value stocks as well as growth stocks.

DIVERSIFICATION

Whether or not you use timing, proper asset diversification is always the best way to successfully navigate an uncertain future. In this article I have used the Standard & Poor’s 500 Index as a proxy for equity investments. This index represents about 85% of the total value of all U.S. stocks.

Unfortunately, at the start of a secular bear market many investors tend to be very over-weighted in this popular large-cap asset class. In the past two years, hundreds of thousands of investors have realized too late that even the mightiest of such stocks can fall with a thud.

In our buy and hold portfolios, we stress having equal weightings among the major asset classes. That means equal amounts of value and growth, equal amounts of small and large in addition to equal amounts of international and domestic stocks.

Each one of these asset classes goes through its own bull markets and bear markets, of various lengths and at various times. But because the media is focused mostly on large-cap stocks like those of the S&P 500 Index, we don’t hear much about the ups and downs of small-cap stocks, value stocks and international stocks. However, the media and investors become very concerned during bear markets that affect the S&P 500 Index.

Often a neglected asset class such as small-cap value stocks can outperform the S&P 500 throughout a bear market, whether it’s cyclical or secular.

Figure 3 shows the performance of various asset classes from 1929 to 1999 split into the same four periods as in Figure 1. Asset classes that outperformed the S&P 500 Index during secular bear markets are highlighted and shown in bold. From 1966 to 1981, small-cap and value stocks significantly outperformed the S&P 500, an index that didn’t even keep up with inflation. In this period, the S&P 500 Index would have turned $100,000 into $254,000, while small-cap value stocks would have turned $100,000 into $910,000!

However, in the 1929 to 1941 secular bear market, bonds were the superior performer. The real return of other equity asset classes was lower than that of the S&P 500.

The problem is that it’s impossible to know in advance which asset classes will outperform and which will underperform. The solution is diversification. During any bear market, the chances are very good that some asset classes will provide better returns to help cushion the poor returns of other asset classes.

Since the March 2000 stock market peak, we have actually had a “stealth” bull market in the small and value stocks, bonds, real estate investment trusts and the value of single-family homes. We emphasize many of these asset classes, in our recommended buy-and-hold portfolios, which produced positive returns in 2000 and 2001 before experiencing a modest loss of about 5 percent in the first nine months of 2002.

Also in Figure 3 you can find the annualized returns of our four recommended U.S. equity asset classes (S&P 500 Index, large-cap value, micro-cap and small-cap value). In the 1966-1981 period, the average of those annualized returns was 11 percent, far outpacing inflation. That’s a very strong argument in favor of diversification.

Market Timing

Another obvious – and very effective – strategy for navigating a secular bear market is market timing. The conventional wisdom on Wall Street and among financial journalists is that timing doesn’t work. We’ve written plenty about this in the past, and the fact is that in a secular bear market, this conventional view is just plain false.

Figure 4 shows the performance of a timing system using the 100-day simple moving average since 1942 on the S&P 500 Index. We often use this timing system for educational purposes because it is a simple way to show how market timing systems work and is representative of those we use in managing investments for our clients. (More information on this timing system can be found in “The Best Retirement Strategy I Know Using Market Timing” on our Web site.) This shows how market timing works on a single asset class.

When timing and asset class diversification are used together, the resulting returns are even better for any given level of risk.

Our long-term goal with market timing is to achieve market-like returns with lower risk. This study shows that in the secular bull markets of 1942-1965 and 1982-1999, timing underperformed buy and hold. However, timing also significantly reduced risk, as it always does. In these periods, the risk-adjusted returns of market timing were better than buy and hold, especially if risk is measured by the worst drawdown or the average of the five worst drawdowns. (A drawdown is the percentage loss of an investment from its peak to its subsequent low.)

Market timing really shines during secular bear markets. As you can see, timing increased returns and reduced risk by 32 percent to 65 percent, depending on the risk measure.

With timing, $100,000 invested in the Standard & Poor’s 500 Index from 1966 through 1981 would have grown to $494,000, at only 50 to 70 percent of the risk of the same investment without timing. (And as discussed earlier, $100,000 invested without timing would have grown to only $254,000, not enough to keep up with inflation.)

For investors who have had their confidence in stocks seriously shaken, market timing is an excellent way to regain that confidence without having to worry constantly about where the markets are heading.

The mechanical timing systems we employ are designed to eliminate the impact of human emotions on trading decisions. That’s especially crucial after the emotional beating that has been inflicted by the current bear market.

Summary

Are we in a secular bear market? Certainly the 2000-2002 market collapse is consistent with the start of previous secular bear markets. Suze Orman said she thinks we’re seeing the start of a prolonged bear market. But nobody can know at this point what the future holds.

Investors with properly diversified portfolios are positioned to take advantage of whatever opportunities come their way. Those who use market timing have a higher chance of protecting their assets, along with their ability to profit from future bull markets.

For people who haven’t yet retired, secular bear markets present a good opportunity to buy assets “on sale” through dollar-cost averaging. If you can maintain the big-picture view that these strategies work over the long term, you’ll sleep easier, stay on track and have energy left over to enjoy life’s more fundamental pleasures.

 

 

Discover how professional money management can help you.  Get a Free Consultation from a Merriman financial advisor.