With A Possible Historic Bear Market On The Horizon, What Are My Options? (Part 2)

If you did not read our first post (Is This a Bull Market or Bear Market? Yes!) discussing the three different views of the market, we made the case for why we expect significant market troubles ahead.  In our last post (With A Possible Historic Bear Market On The Horizon, What Are My Options?  (Part 1)), we discussed two options investors might consider in preparing for a potential historic bear market:

Option A – Ignore the evidence and stay blindly invested

Option B – Place your bets on the downside

We would not recommend either one of the two as discussed in Part 1.  Let’s explore three additional options.

Option C – Buy gold and hunker down

Gold tends to do well in an inflationary environment.  However, a debt reckoning secular phase is almost always accompanied by deflation.  As a result, gold generally performs poorly as strong deflationary forces present formidable challenges for all assets.  Barring any unforeseen banking or social crisis, it is not likely gold will increase or even hold its value; at least during the first part of the bear market.

Gold is like any other investment class; it is driven by supply and demand.  Once a credit crisis takes hold and liquidity freezes up, demand drops sharply as investors look to access cash wherever they can.  As a result, every major investment class comes under pressure in a deflationary driven bear market, including gold.  During the heart of the 2008 crisis, gold was hit hard just like every other major asset class.

That said, gold is an asset with inherent value worth holding long term as part of an overall diversified portfolio.  It has performed well during bear markets that were not overcome with credit and liquidity issues.

For the more pessimistic minded, you might consider acquiring some gold to prepare for a worst-case scenario should there be some type of social crisis and/or if banking assets seize up for a period.  Gold coins could prove to be a viable currency source in those conditions.

There is also a reasonable possibility of interest rate spikes in the U.S. during the second half of the bear market. This could result if demand for the U.S. dollar and/or treasury bonds falls sharply.  If that were to happen, the value of gold would likely spike relative to the dollar.

For those interested in establishing or adding to gold positions, we would suggest buying and physically holding 1-ounce gold coins.  Three of the most recognizable and liquid coins to consider would be the American Eagle, American Buffalo, and the Canadian Maple Leaf.

Advice:  It is a good idea to hold some gold now for its diversity and inherent value.  You may also want to look for additional gold buying opportunities should prices take a hit during the first part of the bear market.  However, gold is not the answer for all or most your financial resources.

Option D – Move everything to cash

A popular saying of many market doomsayers is, “cash is king”.  Holding your cash is better than losing money for sure, but it opens a whole other realm of questions with emotional baggage.  When do I move to cash?  How long do I hold it?  When is the time to get back in?  What if I exceed the FDIC limit and my bank goes under? 

If you move to cash too early, then you will cut off productive market returns that could continue boosting your nest egg and legacy.  The permabear folks were telling us to go to cash 6-7 years ago.  You would have sacrificed significant returns had you done so then.

Also, once in the throes of a bear market, how do you determine the right time to get back into the market?  After it goes down 20%? 40%? 60?  Without a proven methodology, you are just stabbing in the dark and letting your emotions drive your decisions.

We are emotional beings driven by fear and greed in many cases.  Without a discipline, it is impossible to keep emotions out of the picture as you determine what to do with your cash.  If you decide to just stay out altogether, you will likely have remorse about missing the recent bull market leg that could have really made a difference.  You will also likely have remorse once the market enters its 3^rd or 4^th year of a new secular bull market down the road, and you are still sitting on the sideline watching huge opportunity gains go by.  You will have missed the best buying opportunity of a lifetime because you were still nervous, didn’t have a plan, and/or didn’t want to lose money.

Still, having cash is better than being completely market dependent and losing it over time.  If you go that route, here are some things to consider:

If you choose to keep all your money at your bank, only $250,000 is protected by FDIC insurance should something happen to the bank.  In a worst-case scenario where a major disruption of financial markets occurs, your cash is only protected up to that amount.

Better options exist for those cash heavy or concerned with brokerage coverage should a disruption take hold.  For example, Fidelity Investments (our primary custodian) sweeps clients’ cash in to 5 different banks as needed for a total protection of $1.25 million.  They also own “excess SIPC” insurance that covers well over the industry standard of $500,000 for securities.

Advice:  Holding cash is a better alternative than being exposed to an impending bear market of this magnitude, but we still think there is a much better option that will help you maximize your financial productivity. 

Option E – Stay invested with an emotional-free discipline that focuses on protection as well as growth, adjusts to market conditions as needed, and positions you to take advantage of the best buying opportunity of a lifetime.

This is what we strongly advocate, but only if you do so with a proven, well defined methodology that is able to assess markets and position your portfolio accordingly; easier said than done.

One of the hardest things for investors to do is invest without emotion.  To do so, you need a discipline that has proven successful during different market conditions over many years.  This can take considerable time and experience to develop.  If you don’t have the time or any idea where to start, we would recommend finding an advisor that does have a proven methodology they can clearly articulate. There are likely multiple ways to formulate a successful investment discipline that can handle different types of markets, but let me share with you our firm’s general methodology.  It was formulated after learning some hard lessons along the way.

Our portfolios contain complementary active and passive portions.  We will primarily focus on the differentiating aspect of our active piece in this post.

We assess markets by looking at the intermediate term trend and the long-term trend.  Specific tools and formulas are used to determine if we are in an intermediate term (IT) bull market or bear market and if we are in a long-term (LT) bull market or bear market.  As a result, we end up with the following four distinct market types:

Four Types of Markets

Each of these four markets has a distinctive personality.  Across our broadly diversified portfolios, we will adjust allocations for the active portion of our portfolios along a risk continuum according to the type of market we are in.  For example, during the first market type, which shows the markets are in an intermediate term bull market AND a long-term bull market, we invest portfolios in a higher allocation of aggressive investments that do well in bull markets.  In the second market type where the market has moved into an intermediate term bear market, we transition to a higher allocation of defensive positions.  The third market type tends to perform similarly to the second scenario so we use a similar allocation mix.

Our fourth market type is essentially code red, indicating a major bear market has set in.  As a result, we will go defensive and bearish by moving into positions that generally hold up in that type of market.  We will also add some additional hedge positions that can actually thrive during difficult market conditions.

Isn’t this timing the market?

No, it is not.  Markets cannot be predicted or timed, but they can be assessed and followed.  That is all we are simply doing with this approach.  We let the market tell us what it is doing and make allocation adjustments accordingly.

A key to this methodology is using two time periods to assess the market – intermediate and long term. Experience has taught us to avoid using only one time period for market assessment.  This often leads to too many unproductive portfolio moves and whipsaw results.  By using two time periods (long-term and intermediate term), it creates a risk continuum that allows us to transition portfolios more slowly and effectively.  For example, if a two bullish market transitions to an intermediate term bear market, we are still allocated bullishly; just a little less so.  You also want to use a methodology that keeps transactions at a minimum.  We generally make allocation adjustments 2-5 times per year.  They are minimal but effective.

The passive portion of our portfolios is comprised of a complementary mix of diversified market dependent funds as well as strategic funds that have little to zero correlation to equity markets.   This allows us to further enhance and balance out our portfolios.

Our methodology allows us to effectively minimize portfolio volatility by smoothing out returns regardless of the market environment.  We may not always beat market indexes over every sliver of time, but our objective is to consistently generate positive returns and minimize losses.  By doing so, we maximize the impact of interest compounding and position our portfolios to significantly beat the market over the long haul.

In addition to keeping our portfolio balances relatively steady and our emotions in check, we position ourselves to take advantage of the new secular bull market that will begin from the eventual market bottom.  We do not have to guess when the bottom is in; we let the markets tell us.

One of the best attributes of this investing approach is it removes any bullish or bearish bias we may have. It frees us of any regrets or missed opportunities should our current assessment of the economy and markets be wrong.  Of course that would mean for the first time in world history the global economy does stay in a perpetual debt bubble.  In that case, we will inherently be invested bullishly right along with the markets as they defy logic.  Again, emotionless investing is the key to this approach.

Advice:  The best way to protect and grow your portfolios regardless of the market environment is to have a proven methodology that assesses markets from multiple time periods and adjusts allocations accordingly. Portfolios can be further enhanced by including complementary funds that have little correlation to equity markets.  

This approach not only benefits your investment portfolio and legacy, it provides more stress-free results during a time period when stress and confusion become prominent.

“To invest successfully what is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that.”

– Warren Buffet

Posted By Navigo Wealth Management