How to prepare for the next bear market

What are the characteristics, and how can you protect your portfolio?

Introduction

Are we in a bear market? Not yet, in our view. While 2018 saw a 19.8% peak-to-trough drop in US large-cap stocks (S&P 500), we consider this a run-of-the-mill bull market correction, not the beginning of a bear market. We expect the current economic expansion and equity bull market to continue for some time but, even so, you should not wait until the next downturn is imminent to take commonsense steps to plan for a bear market.

By studying bear markets closely, you will learn that they aren’t as dangerous as they seem. Cutting through the many misconceptions, our goal is to help you lay the foundation for protecting yourself against market downturns. In three parts below, we explain why bear markets need not threaten financial success, and how they can be an opportunity to improve long-term returns for those who are prepared.

What is a bear market?

A period in which US stocks fall by more than 20% from a peak. But most bear market damage occurs while markets struggle to recover from this drop.

Part 1: Recognize a bear market

How painful are they, and how long do they last?

Part 2: Protect against a downturn

How can you prepare your portfolio and plan?

Part 3: Open in case of emergency

What steps can you take once in a bear market?


 

Bear market characteristics

We define a bear market as an episode where US large-cap stocks fall by at least 20% from peak to trough. But rather than focus only on the peak-to-trough drop time period, or the drawdown period, we also stress the importance of considering how long it takes for stocks to register another all-time high. After all, the time under water—when markets are struggling to recover from their losses—represents the period in which you may be forced to lock in losses.

A big percentage change for one asset class may represent a relatively minor move for another. So while we use US large-cap stocks as the basis for defining bear markets, this is only for clarity. Well-diversified portfolios—which include global stocks as well as fixed income—are structurally designed to protect against the most painful parts of equity bear markets.

With this in mind, let’s look at US large-cap stock statistics for equity bear markets since World War II in order to evaluate what market cycles look like using our framework.

Peak year

Peak year

1946

1946

1961

1961

1968

1968

1972

1972

1987

1987

2000

2000

2007

2007

Average

Average

Peak year

Length of prior bull market*

1946

169

1961

184

1968

78

1972

31

1987

157

2000

155

2007

62

Average

119

Peak year

Time between market cycles**

1946

204

1961

190

1968

84

1972

50

1987

179

2000

158

2007

87

Average

136

Peak year

Peak

1946

31/05/1946

1961

31/12/1961

1968

30/11/1968

1972

31/12/1972

1987

31/08/1987

2000

31/08/2000

2007

31/10/2007

Average

 

Peak year

Trough

1946

30/11/1946

1961

30/06/1962

1968

30/06/1970

1972

30/09/1974

1987

30/11/1987

2000

30/09/2002

2007

28/02/2009

Average

 

Peak year

Recovery date

1946

31/10/1949

1961

30/04/1963

1968

31/03/1971

1972

30/06/1976

1987

31/05/1989

2000

31/10/2006

2007

31/03/2012

Average

 

Peak year

Max drawdown

1946

–21.8%

1961

–22.3%

1968

–29.4%

1972

–42.6%

1987

–29.6%

2000

–44.7%

2007

–51.0%

Average

–34.5%

Peak year

Time to full recovery (new all-time high)

1946

41

1961

16

1968

28

1972

42

1987

21

2000

74

2007

53

Average

39

Peak year

Drawdown time

1946

6

1961

6

1968

19

1972

21

1987

3

2000

25

2007

16

Average

14

Peak year

Recovery time

1946

35

1961

10

1968

9

1972

21

1987

18

2000

49

2007

37

Average

26

Peak year

Months of prior gains 'erased'

1946

15

1961

36

1968

66

1972

118

1987

18

2000

64

2007

141

Average

65

When assessing bear market risk, it’s important to cut through the taboo that surrounds them. Yes, bear markets are painful. But they are also rare, and over relatively quickly. Since 1945, stocks have spent about two-thirds of the time at or within 10% of an all-time high. In this light, it’s clear that markets behave more like a runaway train than a cycle or clock when viewed over the long term. As an investor, your job is to try to keep up with the train, which rarely stops and never truly goes backwards. This context is noteworthy as you ask yourself how much long-term growth you’re willing to forfeit in order to improve your comfort level during the painful-but-rare pauses.


 

Before the bear shows up

Unfortunately, history tells us that the quest for the perfect hedge may be a wild goose chase. No matter how well-intended or designed, the strategies that provide the most potent protection against equity downside risk also tend to be the most costly as they sacrifice long-term growth potential.

We typically recommend prioritizing cost-effective protection before moving on to less-reliable or costlier hedging strategies. Below are four “damage mitigation” strategies, in declining order of efficiency.

1. Think structurally

Make sure that your portfolio is taking the right amount of risk in order to meet your short- and long-term objectives. If those objectives appear in conflict, the Liquidity. Longevity. Legacy.* (3L) framework may help ensure that your portfolio can meet both sets of goals.

The 3L framework starts with the Liquidity strategy, which is designed to provide needed cash flow over the next 2-5 years, securing your ability to hold risk assets during a downturn.

The Longevity strategy is constructed to include all assets and resources needed for the rest of your life, clarifying what your future spending objectives will likely cost.

The Legacy strategy comprises assets in excess of what you require to meet your own lifetime objectives, clarifying how much your family can do to improve the lives of others now or in the future.

2. Plan strategically

The most direct way you can manage equity risk is to trim some stocks from your portfolio in favor of a higher allocation to government and municipal bonds. With that said, large changes in your portfolio’s allocation should only be made rarely and proactively.

By contrast, we don’t recommend jumping into or out of the market based on short-term forecasts—emotions tend to trump reason once markets become volatile.

We believe it is particularly important to hold well-diversified portfolios during late-cycle environments. Although somewhat-concentrated portfolios can work very well during bull markets, less-diversified portfolios are fragile, exhibiting larger drawdowns and longer recovery times in bear markets.

3. Consider hedges

Many strategies could mitigate your portfolio’s downside exposure if used to replace part of your equity allocation. You can also consider a systematic allocation strategy, hedge funds, or structured notes that accept limited upside in return for explicit downside protection.

In general, we prefer hedging positions that provide meaningful downside protection during a bear market, but don’t cost too much if the bull market continues. These include long-duration bonds, regime-shifting strategies that can cut equity positioning substantially, and certain structured products that cap downside exposure.

As a general rule of thumb, the more perfect a hedge is, the more costly it becomes. If you find something that seems to be an exception to this guideline, tread carefully—it may be too good to be true.

It’s important to remember that downside protection is less important for meeting long-term goals than it seems. Don’t sacrifice too much upside to protect against temporary losses.

4. Manage liabilities prudently

If used carefully, debt may greatly benefit bear market returns. The capacity to borrow can help you avoid selling at bear market prices and can vastly amplify return potential in the first stages of a recovery period. But, if used imprudently, debt can be ruinous.

Debt can be segmented into two categories: strategic debt— generally longterm and helpful for maintaining diversification and flexibility on a balance sheet—and tactical debt—used opportunistically on a short-term basis to improve outcomes. Make sure you manage both carefully to avoid being caught off-guard by a market decline or unexpected liquidity need.

A note of caution: Borrowing costs have increased commensurately with interest rates. Investors should have a plan to pay down debt when markets are healthy. This, along with consolidating assets to increase availability and improve borrowing terms, can help make sure that borrowing capacity is available during bear markets.


 

What to do during a bear market

There are a handful of tactics you can employ during a bear market:

Don’t panic

Remember that bear markets are painful but temporary. Sticking to your plan is key, so resist the urge to change the risk profile of your portfolio or make sizable shifts out of stocks or into cash.

Portfolio management

Use sell-offs as opportunities to harvest capital losses—a strategy that, over time, we estimate can add about 0.5% to after-tax annual portfolio returns. Also, rebalance your portfolio so it doesn’t drift too far from your target allocation. In addition to reducing portfolio risk, this can also enhance upside capture.

Play for time

Look for ways to increase your savings rate or cut back on spending. This is also a time to consider tapping borrowing facilities as a bridge to avoid locking in losses, but don’t take on too much leverage in case markets don’t quickly recover.

Tactical opportunities

While every bear market is different than the last, there is one constant: There are always market dislocations that can provide opportunities to enhance returns. Generally, we recommend leaning in to risk assets when market prices are out of step with fundamentals. If you enter a bear market well prepared, you may be able to unwind portfolio hedges and temporarily increase portfolio risk to take advantage of higher return potential.

Read the full report

For a deeper read, download the full whitepaper, Bear market guidebook: How to prepare for the next market downturn.


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