Introduction
Experienced investors know that the key to successfully navigating a bear market is to carefully manage risk. Ideally, risk management is built into your regular investment process, which means that you have taken defensive steps before the bear market begins. Bear markets feature high stock price volatility that trick investors into making irrational decisions. However, a well-prepared investor can reap significant rewards during a bear market, such as smaller portfolio drawdowns than the overall market and the good fortune to buy high-quality stocks at bargain basement prices.
(Aside: Passive investors have a much easier job during a bear market. They typically continue to dollar cost averaging into a number of low-expense exchange traded funds (ETF’s) and rebalance their holdings on a regular basis. They know that their investments will produce close to market returns. Of course, passive investors also need strength and wisdom to continue following their investing strategy when the stock market experiences a serious setback.)
Start with a High-Level View
Imagine yourself as the Captain of a large container ship sailing in the middle of the ocean. Your ship is carrying about 20,000 shipping containers weighing 165,000 tons. Your ship is not very maneuverable traveling at 24 knots, so caution is warranted.
Your radar picks up a vessel in the far distance. You check your Automatic Identification System (AIS) to improve your situational awareness. This will help you to decide if the other vessel is potentially on a collision course with your ship. This is critically important information because it takes several minutes to change your ship’s heading by 90 degrees. The Captain will watch the situation closely, but in most cases no action or a small corrective action is all that is needed.
A stock investor also benefits from taking a high-level (long-term) view of the investment process. The captain of a containership does not make rapid alterations in heading. Instead, they observe what is happening on the horizon and make small alterations to their course when needed. Likewise, a stock investor should consistently follow the path towards his financial destination and only make minor adjustments along the way.
Author Howard Marks1 suggested that “cycle positioning” and “asset selection” are the two main tools in portfolio management. Cycle positioning refers to the process of deciding how much risk to take in response to judgments of where the market cycles are at the present time. Asset selection is the process of deciding appropriate weightings for different markets and securities. See Planning for Better Investment Results (Part 2) for a discussion on asset allocation.
Stock investors need to be aware that bear markets occur with some regularity. They should always be mentally prepared for a 50% drawdown in the value of their equity holdings. Ideally, investors will manage risk during the latter stages of a bull market as stocks become expensive. These steps might include selling lower quality holdings, taking some profits from big winners and rebalancing their stock/fixed income allocation back to their target allocation.
The S&P 500 index peaked at 4796 on January 3, 2022, and finished the year at 3849, a 19.7% retreat from the highs. The market officially entered bear market territory (down 20% from the peak) in mid-June 2022. Likewise, the S&P Canada Aggregate Bond Index lost 10.55% in 2022. Normally, bond prices go up when stock prices decline during a bear market, but there are no guarantees in investing. In 2022, both equities and bonds suffered double-digit losses due to the rapid rise in interest rates by central banks.
The high-level view indicates that the S&P 500 index is currently stuck between the January 2022 high and the October 2022 low. No one knows where the market is headed in the short term. Taking a longer term view, the S&P 500 climbed over 600% from the March 2009 lows until the January 2022 high. The maximum drawdown from the high was only 25%. For this reason, I am mentally prepared for another leg down in the bear market although there is no guarantee that this will happen. I will maintain a defensive posture and prepare for buying opportunities in late 2023 or 2024. How does an investor do this?
Develop a Watchlist
The first step is to create a new watchlist of stocks to follow closely. For an experienced investor, the watchlist will mostly contain stocks that they already own. Adding to positions that you are familiar with and that have performed well is often the best strategy. Of course, it is important for DIY investors to carefully manage the size of their stock positions. My rule is to never add to a position that exceeds 5% of my equity position. However, I am always looking to increase the size of my favorite positions when they drop significantly below a 5% weighting.
Experienced investors may also have a few stocks that they would like to own. My wish list includes Canadian National Railway, Texas Instruments and Microsoft. So I have these stocks in my watchlist as well.
Many investors re-invest their dividends and put new money to work immediately. Most of the time this is the best strategy. As a retiree, I am not rushing to put additional cash into the stock market when it is arguably still expensive. (Yes, it is 20% cheaper than it was in January 2022 and I did put some money into the market in June and October 2022.) When an investor pursues a strategy other than dollar cost averaging (DCA), it is critically important not to fall asleep and watch the stock market bottom and rise again without taking any action. Another way to put it is don’t overthink the situation and miss a big opportunity. How do I do this?
The way that I avoid overthinking is that I establish target buy prices for each stock in my watchlist. I commit to buying each stock as it hits my target buy price unless the company’s fundamentals have significantly changed. As time passes, I continue to monitor my watchlist and fine tune my target buy prices. In case anyone is interested, I enter target buy prices in the Globe and Mail’s Watchlist tool so I get alerted when they hit my buy price.
I use a number of tools to determine stock buy prices, including discounted cash flow (DCF) valuation, current dividend yield compared to its average and highest dividend yields and technical analysis (support prices, Fibonacci retracements, etc.). I basically look for different methods that point to similar entry prices for adding to a position. It is even better if it looks like the entry price may occur at the beginning of seasonal strength for the stock. My thinking is that the more tools an investor has in his/her toolkit, the better the odds that they can pick good stock buy prices. See Valuation: Buying Dividend Growth Stocks at the Right Price for further insights on stock valuation. Moreover, an observant investor gains insight into how a stock trades after they have held it for several years.
I know this sounds simple, but the market likes to play tricks on the investor’s mind. As of today (March 20h), the S&P 500 sits slightly below critical resistance in the 4200-4300 level. If the market declines, I will continue to watch the stocks on my watchlist for good entry points. I have also done some thinking about what I will do if the market continues to go up. My conclusion is that it would make sense to trade an index ETF to take advantage of the rising market while only having to sell one ETF when the bear market returns. I think this is a solid strategy for a pragmatic value investor.
Take Advantage of Price Volatility
Experienced investors know that risk is determined by the quality of a business, the excellence of its management and the price paid for the stock relative to its expecting earnings (or free cash flow) over the long term. You can read more about the traits of high-quality businesses in Four Qualities that Propel Successful Public Companies in the Long-Term. An investor that buys shares in a high-quality company run by competent management when it is trading at an attractive price is making a low-risk purchase. Investing doesn’t need to be more complicated than that.
Modern Portfolio Theory (MPT) uses price volatility as a proxy for risk. I do not agree with this premise because risk involves the chance of a permanent loss. Some sectors of the economy are more cyclical than others, but this doesn’t mean that all stocks in cyclical sectors have a higher risk of permanent loss.
Canadian Tire (CTC/A.TO) has been one of Canada’s most trusted and iconic retail brands over the past 100 years. The company operates in the consumer discretionary sector, which is one of the more cyclical sectors. The company purchased a small financial services company in 1968 and later established the Canadian Tire Bank in 2003. The Company provides credit to its customers and its customers are fiercely loyal to the firm.
Canadian Tires benefits from customer loyalty when the economy is going well, but tends to suffer losses during recessions as some of their customers can’t repay their debt. The Company’s stock tends to drop precipitously during recessions. This often provides investors with the opportunity to pick up shares of a great Canadian success story at a discount to book value. Long term, the Company has always recovered due to its iconic brands and loyal customers. I believe that when Canadian Tire’s stock drops below book value, it presents a great buying opportunity for investors.
Seek Out-of-Favor Sectors
One of the things that gets me excited as an investor is seeing an entire sector of the economy going out of favor. This typically happens because too many investors chase hot stocks, which leaves stocks in out of favor sectors vulnerable to price drops. I have a basic trust that high-quality stocks that are out of favor will revert to their norm in due course far more often than they will lose their way forever. I will give you a couple of recent examples to illustrate my belief.
Everyone remembers that crude oil dropped below zero at the beginning of the pandemic in 2020. The share prices of oil and gas companies were rapidly falling, which led to panic selling by many investors. This was one of the great buying opportunities of a lifetime for investors to buy high-quality oil and gas stocks. I owned a small position in Imperial Oil (IMO-T) prior to the pandemic and knew that the Company had a stellar balance sheet. I bought several tranches of IMO stock as its price declined. My original IMO shares have nearly doubled in price from my purchase price and the last tranche I bought has nearly quadrupled in price. It really pays to be a buyer when other investors are panicking.
I would be remiss not to state that several of the lower-quality oil and gas companies were taken over or went bankrupt during the pandemic, but the highest-quality companies have all done exceedingly well. Investors should always remember that high reward opportunities involve an element of risk. The secret is to manage this risk by investing in high-quality names and buying only up to your risk tolerance.
The second example I will talk about is the defense sector. In early 2021, all of the defense sector companies were trading at depressed valuations. Some of the companies, Boeing (BA-N) for example, were not doing well due to enormous losses suffered by aerospace companies during the pandemic. On the other hand, it was evident that geopolitical tensions were flaring up in several parts of the world. These tensions would likely be exacerbated due to deglobalization forces resulting from supply chain issues revealed during the pandemic.
I took a position in Northrop Grumman (NOC-N) in February 2021. The stock price began to take off shortly thereafter and almost doubled in price by October 2022. It has recently had a healthy pullback from its highs. I expect that the defense sector will do very well this decade as revitalization of defense capabilities is an expensive proposition and takes many years. I know many investors shy away from buying defense firms, but Russia’s invasion of Ukraine has shown that authoritarian regimes will try to expand their influence when they believe their opposition is weak. A strong defense will often reduce military confrontations in the world.
These two examples show the benefits of seeking out sectors of the economy that are out of favor. The U.S. sector ETF’s (XLF, XLU, XLE, etc.) provide an easy way to determine which sectors are underperforming the market. An investor can then drilldown into the underperforming sector ETF’s and identify the high-quality companies that are worthy of more detailed investigation.
Summary
This article provides useful insights into what an experienced value investor does during a bear market. There are a multitude of ways to make money in any market, including bear markets. For conservative investors, one of the best approaches is to continue to learn more about high-quality stocks that you are interested in owning, determine appropriate prices to pay for the best ones and act decisively when a compelling investment opportunity presents itself. This approach helps me to avoid both fear- and greed-based urges present themselves when markets are volatile. As we all know, fear- and greed-based decisions often lead to expensive investing errors.
I look forward to hearing how you are navigating the bear market.
References
- Marks, Howard, Mastering the Market Cycle: Getting the Odds on your Side, Harper Business, 2018.