What are Bear Markets?

A bear market is often arbitrarily defined as a market in which the value of stocks have fallen 20% in value from their previous peak price.

The Standard and Poor’s 500 (S&P 500) stock index officially entered into a bear market on July 7, 2008, after it fell 20% from its all-time peak of 1,576 in the previous autumn. The U.S. stock markets have been in bear market territory approximately 18% of the time since 1950 in ten separate bear market events.

Changing Investment Strategies for Bear Markets

Clearly some investments will do better in bear markets than S&P500 Index funds –which by definition will be dropping at least 20%. If you are certain that a bear market is starting, you could bet against he market by buying puts pegged to the Dow or NASDAQ.

If you are less adventurous, health care and consumer staples companies tend to do well in bear markets since people need to buy prescription drugs, soap, and disposable diapers regardless of how likely they are to be working in the following months. Cash, as they say, is a position and it will probably do very well in a bear market – at least compared to stocks.

The problem with these strategies is that it is very difficult to assess when a bear market is starting. Even if you believe the stock market is over-valued, there is nothing that prevents the market from becoming even more absurdly over-valued (as it did through the end of 2007).

How Should You Invest?

There really is no great bear market investing strategy. There is only good investing strategy. You could spend the rest of your life reading all of the books that have been written on investing strategy. However, there is a consensus among investment professionals:

- Your investments should be widely diversified

- You should take full advantage of any tax-deferred investment vehicles that are available to you – especially those that involve an employer match

- Your investments should be compatible with your investment goal – saving for retirement and saving to buy a house require different investment strategies

- You should have a reason for making any investment and should periodically revisit that investment to make sure your reason is still valid

- You should not have more than 5% of your portfolio in any given investment

- You should understand what your risk tolerance is and how risky your investments are, and make sure the two are compatible

- Your investment portfolio and strategy should change as you get closer to retirement and your ability to recover from a bad investment is reduced by your reduced future earning potential

Investing for Bear Markets

It makes little sense to have a special strategy for bear markets because you will already be down 20% before a bear market officially gets under way. And then, if you were to change your strategy to align it with the bear market, you could be sorry if the market immediately turned around as it did in 1957.

However, there are at least two popular techniques that claim to work in both bull and bear markets – technical analysis and mechanical investing. Technical analysis assumes human behavior is constant through time and hence investors today will react exactly the same way their grandparents did to changing market conditions. If that is true, then short-term market moves can be predicted based on recent market prices by looking at historical market reactions to similar stock market patterns. Mechanical investing implements a system – and there are thousands, if not millions, of systems and many of them involve technical analysis – which attempts to model future stock market prices based on various input values. However, there are no famous billionaires who made their money through technical analysis or mechanical investing.

Additional Resources

• Mechanical Investing: www.mechanical-investing.com/stock-investing-strategies.html

• Technical Analysis: http://www.leavittbrothers.com/education/technical_analysis/

• Warren Buffett’s Letters to His Investors: http://www.berkshirehathaway.com/letters/letters.html