Three ways to profit from bear markets

Most value investors already know why bear markets are an investor’s best friend.  

Bear markets may be scary, but they’re the best time to pick up wonderful businesses at attractive prices.

Why are bear markets the best time to invest?  

Well, in bull markets, you can still find wonderful businesses at low prices, but often there’s a major problem causing that low price.  In a bull market, investors will buy anything that moves unless it has a ‘bad news’ stink.

But in a bear market, you can have a great business, doing everything right, and the share price still gets whacked just because investors are moving wholesale into ‘safe’ assets like cash or bonds.  Snapping up high-quality investments in a bear market is the mark of an outstanding investor.

As Warren Buffett put it recently:

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

So if bear markets are good, how do we profit from them?  Here are three strategies:

1. Wait for a bear market and then dive in

There are various technical descriptions of a bear market, a common one being a 20% drop in the broad market index over a month or two.  Most investors can spot a bear market because they start checking their portfolio even more often, and thoughts about selling start to creep into their minds.

There are a couple of problems with this approach to spotting bear markets, though.  A 20% decline may sound like a lot, but in 1999 the FTSE 100 was at almost 7,000, and a 20% drop still left it with a stratospheric valuation.  A 20% drop took the market to 5,500 in mid-2001, and returns since that point have been terrible since we’re still at 5,500 a decade later.  So there is more to a bear market than how much the market drops by or how much you’re sweating about it.

Robert Shiller and Andrew Smithers have both produced research around market valuation tools and have both concluded that a useful measure is the real PE10, otherwise known as the cyclically adjusted PE, CAPE, or price to 10-year inflation-adjusted earnings ratio.

When CAPE is below its long-term average, returns tend to be better, and when it’s above the average, future returns tend to be worse.  So in 2001, when we were in ‘bear market’ territory, the FTSE 100 CAPE valuation was around 20, which is well above the average, which is somewhere between 12 and 15, depending on whose data you look at.  Either way, it was a bear market, but it wasn’t cheap.

However, by 2003 the market had dropped to 3,500, some 50% down from the peak.  Returns from 3,500 have, of course, been better than they were from 5,500; a lower starting point must always produce better results than a higher starting point (assuming the index doesn’t go to zero, at which point we’d have other things to worry about, like finding the nearest shotgun and tin of beans).

But, 3,500 in 2003 still wasn’t exactly a golden, once-in-a-lifetime opportunity, even though from that point forward, returns to 2008 were pretty good.   With a CAPE of around 13, this was barely cheaper than a fairly valued market.  It just looked super-cheap in comparison to the insane dot com valuations we had become accustomed to, which is a process known as ‘anchoring’ to behavioural economists.

To get a really cheap market, you would have to wait until 2009 when the market hit 3,500 for a second time.  But by this time, the market had grown due to inflation, population growth and the general forward march of capitalism, so in 2009, the FTSE 100 at 3,500 gave a CAPE valuation of around 9.  Finally then, we had a market that was, very likely, cheap by any reasonable measure.  And the returns from 2009 have born that out.

The problem here is that waiting for a bear market can be a very long and boring game, requiring the patience of Job.  In fact, I think it’s likely that there wasn’t an attractively valued FTSE 100 between 1983 and 2009.  The rest of the time, it was either just okay or expensive.

2. Go looking around the globe for bear markets

There is a saying that “there’s always a bull market in something”, and this may mean that there’s always a bear market in something, somewhere.  If you have the data and the tools to interpret that data, then I think that trotting the globe to find value is probably the best approach because it widens your horizons enormously.  Many global investment firms like this approach, from Tweedy & Browne to GMO and SocGen.

But alas, for most of you and me, I guess, global value investing is a difficult and worrying proposition due to lack of data, lack of trust and a general fear of investing overseas in companies that are even more removed than those of the UK-focused FTSE indices.

This leaves my preferred option, which is…

3. Create your own bear market

No, I’m not talking about single-handedly derailing the global economy or going onto some internet forums to stoke up fears over the Euro Crisis, or spreading rumours about individual companies.

I mean that it’s possible to create an index, much like the FTSE 100 or DOW 30, full of large, global companies, in which the valuations of the individual companies, and therefore the index as a whole, are always in bear market territory.

The premise is simple.  If the market indices tend to produce above-average results when they are in bear markets with bear or even depression market valuations, then why not create an index that is always in this ‘hot valuation zone’ where future returns are always likely to be above average?

Of course, as an index, it would have to have a fair number of companies.  Perhaps 20, 30 or even 40.

It would have to be full of companies where you could make a reasonable guess about their bear market valuations using the tools developed by Shiller and Smithers.  In other words, they’d need a 10-year earnings history so that you could calculate PE10 or CAPE figures for each company.

Since the broad market indices always pay dividends and almost always grow their earnings over time, you’d need a bunch of companies that, at least as a group, were likely to always pay dividends and grow over time.

If you could build an index of companies where the earnings and dividend growth were at least comparable to the market indices (and preferably better), and which had a lower PE, a higher dividend yield, and a lower PE10 or CAPE valuation, then I think it would be reasonable to assume that such an index would probably beat the typical, market cap based index over time.

You would need to actively manage the portfolio in order to keep the yields high and the valuations low.

So, much like the FTSE 100, which has a quarterly review where they replace those with the lowest market cap, you’d have to occasionally replace the constituents of your index which had the highest valuation, i.e. those that looked most like they were entering bull market territory rather than still being in a bear market.

Most of the time, this would mean selling the shares of those holdings that had gone up in value the most, rather than the FTSE 100, which gets rid of those that have typically gone down in value the most.

Every time one of this index’s constituents enters a bull market, it is sold, and the profits are realised.  With the FTSE 100, when it enters a bull market, the speculative profits show up at the index level but are never realised unless the investor actively makes the decision to sell out.

Since valuations tend to be mean reverting, if investors don’t sell out at the top of a bull market, they then are doomed to sit and watch their speculative profits evaporate as valuations mean revert back to normality.

On the other hand, this ‘permanent bear market’ index should usually gain from valuation mean reversion since most constituents have below-average valuations, so any mean reversion results in an increasing share price.

Learn to love bear markets

Learning to love bear markets is one of the most difficult and yet most profitable goals that any investor can achieve.  Those who really love bear markets may love them so much that they’ll want to create their own ‘permanent bear market’ index to ensure that they are always getting the higher returns that bear markets have historically produced.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

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