My Writing

From the October 20, 2006 Break Out Report

Beware the Ides of October!

by Marco den Ouden

One of my friends, Tom, recently said he was getting increasingly bearish and believed this fall we would see a one day market drop to rival Black Thursday in 1929 or Black Monday in 1987. Both of those, ominously enough, occurred in October. This fits with the cyclical theory that says the best time to be in the market is from November through April.

Tom and other gold bugs have said that the bear market that ran from 2000-2002 is not over yet. Such analysts talk about “secular” bear markets. Ordinarily a bear market is defined as an extended market decline of greater than 20% lasting at least two months. But a secular bear market is a long term trend. Some argue that alternating secular bull and bear markets run for an average of 17 years (inflation adjusted).

A prime example of the difference between, say, a bear market and a secular bear market would be that Black Monday crash of 1987. On Oct. 19^th the Dow dropped 507.99 points or 22.61%. By year end the Dow had recovered half of that and a year later had recovered the full amount and by August of 1989, the market had surpassed its previous high. Even though it took two years for the Dow to pass its previous high, that crash was a cyclical bear market within a secular bull market. In other words, a correction within a long term trend.

By contrast, the Dow today still has not surpassed its high of 11,908.50 set on January 14, 2000. That’s six and a half years without hitting new all time highs. If you add in inflation, the Dow has dropped even more in real terms. And if you compare it in other currencies, say the Canadian dollar, the Dow has lost ground big time.

So the bearish pundits may be right. We could well be in a secular bear market. Perennial bulls like Harry Dent, of course, argue the opposite. Dent says the crash of 2000-2002 was a correction within a secular bull market that will end around 2010.  The evidence favours the bears.

In an article in Fortune Magazine in 1996, Susan Kuhn used a looser definition of a bear market – a decline of 15% rather than 20%. She wrote that there had been 14 such bear markets since the fifties with an average decline of 24% over eight months. That was just peak to trough. Recovery time to regain old highs was an average of thirteen months. On average someone holding a portfolio mirroring the Dow from the start of a bear market to its eventual recovery would have had a 21 month spell of no growth whatsoever.

That’s just the average. The devastating bear market of 1973-1974 took 7 years, 1 month and 13 days to recover lost ground. And the crash of 1929 took 25 years for the Dow to hit new highs again.

And if the Dow currently looks weak, what about the NASDAQ? It peaked over 5000 in 2000 and today sits around 2150, down 60%. The argument for a secular bear market in the NASDAQ is even stronger than that for the Dow.

So bear markets, cyclical or secular, can be painful. But can they be avoided?

The very real problem is that safety comes at a price. Mark Hulbert of the Hulbert Financial Digest has argued that newsletter writers with the best track record for safety (lowest drawdowns) have poor over-all track records because they are not only out of the market when it is going down, they are also often out of the market when it is going up. So what they avoid in losses, they fail to make up in gains.

Even very smart guys like James Dale Davidson and William Rees-Mogg predicted in their classic 1993 book The Great Reckoning  that the 1990s would be wracked by a great depression. Investors who sold their stocks and moved to cash would have missed out on one of the greatest stock market booms in history.   The  book  was  prescient  in  many  ways, but the timing was out by around seven years.

Most experts agree that it is next to impossible to predict what the market will do, at least in the short term. Over the long haul, markets will rise. And they will rise faster than the rate of inflation and faster than prevailing fixed income returns.

In fact, every bear market throughout history has been followed by a bull market that has taken equity values to new heights. That doesn't help, though, if we suffer a 1929 style crash and bear market. Baby boomers like myself, who are within 25 years of retirement, cannot afford to wait 25 years to see our investments recover lost ground! So we need to be prepared, to adopt a strategy to cope with the bear markets. Here are a few ways.

Diversification

This is probably the easiest and most widely used method to prepare for a bear market. It is sometimes called asset allocation. Basically it means following the old adage "Don't put all your eggs in one basket." How you diversify should be determined by your own unique circumstances, your risk tolerance, your age and so on. It may be wise to do this in consultation with a financial advisor if you are not sure what is best for you.

Susan Kuhn noted that some unusual investments often outperform stocks during severe bear phases. From 1968 to 1979 stocks returned an average of only 3.1% a year. Gold, Chinese ceramics and stamps, on the other hand, returned a handsome 19% a year. During any particular period of time, some investments will outperform others. Certainly gold has been a dynamite investment since the crash began in 2000, as has been the energy sector.

Bear Funds

There are a number of hedge funds and contrarian funds available. These include some of our Power Performer mutual funds – Friedberg Diversified, Sprott Hedge Limited Partnership, Epic Limited Partnership and Northern Rivers Innovation Fund. Most are considered high risk though and often require a hefty minimum investment. You can buy as little as $2000 of the Friedberg fund but must have a net worth excluding house and cars of $75,000. A small investment there may be a good hedge against really bad times.

American readers can check out David Tice and the Prudent Bear website where he promotes the Prudent Bear Fund. Tice advises you to "never buy what a stockbroker tells (you) without doing some independent research ".

Value Investing

You may have read that Warren Buffett, the world's greatest investor, pays absolutely no attention to the stock market. He looks for solid companies with a proven track record and a potential for continued growth that are currently undervalued by the market.  When the stock market crashed in 2000, Buffett’s company Berkshire Hathaway soared. It has done very well in the last six years, more than doubling since the spring of 2000.

Conclusion

Even if we are in a long term secular bear market, you can make money. David Simons, writing in Forbes, noted that the long running Japanese bear market has been punctuated by six rallies of 20% to 60%. Currently the Japanese market is in another even stronger rally. This has been echoed in the American markets where we saw significant gains in 2003.

As for this October, don’t sweat it worrying about something that probably won’t happen. Focus on your stock picks, diversify and have your stops in place and you should be okay.

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