Tuesday, January 8, 2008

fear the bear?

Bear Market: A market condition in which the prices of securities are falling or are expected to fall. Although figures can vary, a downturn of 15-20% or more in multiple indexes (Dow or S&P 500) is considered an entry into a bear market.
Recession: A significant decline in activity spread across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP).

These two terms are usually taken in investing to have negative connotations. Anyone who is long the market probably does not want either one of these scenarios to occur. However, is this reaction really justified? If a bear market or recession or both occur will the net long term results on my investments be negative? Is this something I should be afraid of?

Well, I've never invested through either of these scenarios, so I can not be sure. Let's assume that we went into a bear market in equities while the North American economy dropped into recession. How would this affect my non-registered portfolio? These might be some of the likely advantages and disadvantages of such a situation:

Disadvantages
  • Portfolio paper value might shrink for the duration of the bear market due to negative investor sentiment and shrinking earnings growth.
  • Company earnings from North American activities might grow slower or even decline for the duration of the recession.
  • Company dividend increases might grow slower, stay flat, or even decline for the duration of the recession.
  • Commodities could fall substantially, due to falling demand, causing stocks like Petro Canada (PCA) to plummet.
  • Watching the daily happenings in the market would be depressing.
  • Total market returns for this period should be negative, and could be below -10% annually.
  • This period will be a bad time to sell investments.

Advantages

  • Quality dividend growing stocks may fall to very low levels causing buying opportunities. These stocks may be able to be bought for low prices, and high yields.
  • Some stocks like Procter & Gamble (PG), Johnson & Johnson (JNJ), and Walgreen (WAG) may outperform due to their defensive nature and non cyclical earnings streams.
  • Non-North American business should still grow, albeit slower.
  • Dividend payments will still come, and dividends will still grow, perhaps at a slower pace.
  • Energy prices might fall causing a significant reduction in input costs for most companies.
  • A bear market and recession are usually followed by a period of growth and prosperity.
  • Long term this period should actually boost my returns if I continue buying. In other words, this period should be a good time to buy investments.

Looking at things this way, strictly from an investment perspective, I hope this occurs. To me, the advantages outweigh the disadvantages if and only if I behave in this way:

  • Do not sell any investments
  • Keep buying companies that grow their dividend every year, that I deem to be cheap
  • Don't let bad market sentiment get me down

The earnings of the stocks that I currently own should be fairly resilient to a recession. I would imagine my paper losses would be the greatest on economically sensitive stocks like Petro Canada (PCA), Reitmans (RET.A), General Electric (GE), and Scotts Miracle Gro (SMG). Several of the remaining stocks might actually be viewed as safe havens in times of trouble.

What we should probably fear more as investors is a bubble situation as occurred in the late 1990's. Although a different set of adaptive behaviour might be required in a bubble. Judging by stock valuations currently, I am pretty sure we are no where near a bubble.

U.S. recession is here already?

15 comments:

Susan said...

Great piece! I have saved it for future reference (in case of a bear market).
Thank you.

John said...

You should be very afraid of a bear market

That is why a balanced portfolio with a % in bonds makes sense

Look at a picture of the S&P over time

http://docs.google.com/Doc?id=d5nnw7r_0dqt7njds

Then ask yourself where in the cycle we are.

If you invest in stocks at the wrong time in the cycle you will never make it up

MG said...

John, I would argue that you can negate that effect if you invest in stocks throughout the cycle and stick to quality dividend growing companies.

I agree that if someone went 100% equity in 1999, they would have felt some serious pain for the next four years but that is not really relevant for a long term large cap investor.

I will likely put just as much capital or more into dividend growing stocks in 2009 vs. what I put in in 2007. I won't need the money until at least 2019 or so...

I also get fixed income exposure by paying my mortgage down.

J. said...

mg, good post as usual.

Just a note that the advantages of the bear market are only valid if one manages to keep his/her job, be able to save and add to his/her portfolio.

Otherwise, one has to sell ...

MG said...

good point j., I only structured my post around the fate of my non-registered portfolio, but your comment about employment is very true.

Anonymous said...

Good post. May I have your opinion on Citi Bank (C)?

Thank You.

Dividends4Life said...

MG: Another great post. I will say I don't follow the market as a dividend investor as I did when I was an aggressive growth investor. As you noted, there are upsides to a declining market.

Best Wishes,
Dividends4Life

FinancialJungle said...

The chart posted by John is very deceiving. What's that word I'm looking for? It's not logarithmic?

Anyway, the spacing on the Y Axis aren't gradually squeezed nearer the top, therefore gives you a false impression that the market is way over valued and due for a major correction.

Beside, I doubt the chart accounts for the depreciation of the US Dollar.

telly said...

Bootom line, if you're still in the accumulation phase, as many of us are, you should view it as an opportunity. If you're retiring within the next few years, or are currently retired...yes, you should fear the bear.

MG said...

anon, I don't follow Citi that closely. They are obviously not my first choice in U.S. financials as i would look to BAC, WFC, or USB first.

Citi will likely be fine long term, however i will not be surprised to see them cut the dividend which will probably help the stock.

Sami said...

i agree with your conclusions.

i want to add that the market has yielded positive returns during rescissions. In other words a bear market and rescission may not go hand in hand.

John said...

For f jungle and other fans of logarithms here is the S&P in a log scale

http://docs.google.com/Doc?id=d5nnw7r_1f44729gv

If you want to see it currency hedged compare it to XSP

Anonymous said...

looks like John was right

MG (moneygardener) said...

how so?

Anonymous said...

The market was way over valued