Bear Market Survival Guide

Many investors simply follow the winding paths of bears and bulls, finding comfort each time the market appears to be coming out of the woods. But what does this mean longer-term?

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Markets trade far from linear in nature. Historically, movement in opposite directions is common before a trend in one direction becomes apparent, in both shorter time periods and longer ones. Many investors simply follow the winding paths of bears and bulls, finding comfort each time the market appears to be coming out of the woods. But what does this mean longer-term? Do investors simply surrender to current market sentiment when making investment decisions?

One thing is certain when assessing volatility and how markets have traded historically: There will be downturns, some far-reaching. Bears are rarely foreseen and will usually come when investors are feeling quite optimistic. Unknowable events, they tend to bait the more severe market reaction, naturally.

Recognizing that bears (in the future, at some point) are inevitable — how can investors position themselves appropriately, taking advantage of strong markets while acknowledging that downturns can and do occur? Here, we are not forecasting a bear market, but using history as our guide. Facts and learnings based on prior bear markets can help us to prepare for similar situations going forward.

Planning Required: Bear Encounters Ahead

Understanding the dynamics of the market — and planning accordingly — can help you to bode well when faced with a bear, while continuing to meet your investment objectives.

Volatility is often a sign of uncertainty about the downside. Add to that the more global nature of 2016 markets (growth in China, softness in the economies of Europe and Japan, heightened terrorism alerts, central bank action). The year got off to a hairy start in January and early February but rebounded sharply. Markets typically overreact, and sentiment tends to exacerbate in times of distress. Given this, future swings may be much larger than investors are comfortable with. Trying to time such market declines would prove unfruitful; it is tough (if not impossible) to catch the absolute bottoms and tops.

The key to weathering these challenging environments is in the planning. Without proper planning, investors could make less-than-optimal, reactionary decisions. Since the S&P 500 historically has experienced a hefty decline (a 20% drop in stock values) about once every 2.5 years, retirees and pre-retirees who are more vulnerable to bear encounters should prepare for this imminent reality. Longer-term investors may be able to navigate with greater ease. This leads us to the important “mapping” exercise of asset allocation, an essential trailhead for all investors.

Using a Map

Asset allocation is at the heart of investing. Your asset allocation is determined when you write your Investment Policy Statement: the map that takes into consideration your goals, objectives, and appetite for risk — including tolerance for volatile environments and the potential bear encounter. The mix of assets that you employ may help to reduce volatility through diversification.

For example, look at stocks and bonds. Since 1926, 28% of stock market and 8% of bond market returns were negative on an annual basis. But only rarely (about 2% of the time) did stocks and bonds post simultaneous annual negative returns. Managing the stock-to-bond allocation can have a significant effect on the stability and predictability of portfolio performance.[1]

The very act of building a sound asset allocation strategy can help mitigate the danger of distraction. What this means: If you know your plan was mapped for the long-term and recognize that volatility is bound to occur along the way — then there is no impulse to make a quick, reactionary decision when the bear shows face. You stick to your strategy as it was laid out, confident that it’s geared toward achieving your specific financial objectives, risks considered.

Check Your Footing

Once the map has been drawn, check your footing systematically. Yearly rebalancing is wise to accommodate changes in personal risk tolerance and market environments.

If changes in market prices have caused your portfolio to veer from its original path, the impact could carry through to longer-term goals. For example, a robust stock market, while beneficial to asset growth, can tilt a portfolio more heavily toward stocks. Rebalancing back to plan may require selling some stocks in favor of more income-producing assets, such as bonds.

While you might adapt some portions of your asset allocation based on market conditions — it would not be wise to change investment plans based solely on the market. The 2007– 2009 financial crisis provides a strong example of this dark reality.

The S&P 500 hit a peak in mid-October 2007 at 1,576 and hit bottom in March 2009 at 667 — a stomach-churning decline of about 58%. Anyone selling stocks during that decline probably felt okay about the decision while stocks continued to feel pressure. And then, before the economy began its recovery, stocks began their rebound. With the S&P 500 reaching 1,950 in February 2016, stocks are now selling for about 290% of the low index value.

Selling stocks based on price action alone required two correct decisions to be successful: when to sell and when to buy back. It is unlikely that anyone would have been able to time those two transactions perfectly. Anyone who sold stocks and moved to cash during this time would now be behind on performance. Worse, anyone who sold out near the bottom would’ve lost so much of the rebound opportunity; net worth would be permanently impaired. This shows the importance of staying invested — and not allowing a bear market to dictate a different path through the woods.

Using a Ladder

The goal of a bond ladder is to provide a consistent flow of income based on bonds maturing at different times. This is one way to construct a cash cushion (see: Using a Safety Net, at right). The correlation between stocks and high-quality bonds tends to waver over time. As we saw in 2008, during severe market distress, the correlation is usually low. Only twice in the past 85 years have both stocks and U.S. government bonds posted simultaneous annual negative returns.

5-Year Bond Ladder

Source: PNC

Consider Your Alternatives

For qualified investors, alternative investments — such as hedge funds, private equity, real estate and natural resources — aim to reduce downside risk while maintaining (or even increasing) total expected return. Adding alternatives to a traditional allocation may assist in achieving this, with just one caveat: Alternatives highly correlated to traditional assets do little to improve a portfolio’s efficiency. The idea is that alternatives tend to have lower correlations to one another, and adding additional low-correlated strategies can increase diversification.

Once a little-known option limited to ultra-high-net-worth investors, hedge funds are now commonly used alternatives in the wider investment community, including institutions, endowments and individuals with lower net worth. Hedge funds have come under pressure as of late due to performance. While they indeed underperformed stocks in the past five years, long-term performance (2000-2015) has trended well. Additionally, hedge funds have had a better downside capture than stocks or bonds. This means that in cases where stocks or bonds declined, hedge funds outperformed.[2]

Source: Ibbotson Associates; Morningstar; HFR Asset Management, LLC; Barclays Capital; Standard & Poor’s; PNC

Stay the Course

When faced with the unavoidable bear, stay on path and do not panic-sell. Creating a long-term strategy and not swaying from it is historically the best way to achieve investment goals.

The power of staying invested is clear. For a 20-year period ending in 2015, the market experienced an average annualized total return of 8.2%. A $10,000 initial investment — assuming you stayed fully invested for the duration — would have grown to $32,839, not including the reinvestment of dividends (which would bring that figure closer to $50,000). Using the price appreciation only, if you pulled money out during that 20-year period for whatever reason, you’d be significantly worse off — because it is hard to catch the upturn in the market.

  • Missing the 10 best days, your balance would be worth $16,401 ($16,438 less)
  • Missing the 20 best days, your balance would be worth $10,225 ($22,614 less)

When volatility strikes, remember the components of the bear market survival guide — the crux being that it’s generally best to stay invested and ride it out.

Bill Stone Chief Investment Strategist PNC Asset Management GroupBill Stone is executive vice president and chief investment strategist for PNC Asset Management Group. He is responsible for leading the strategy teams for PNC Wealth Management®, PNC Institutional Asset Management® and Hawthorn, PNC Family Wealth® in monitoring the factors that influence the direction of domestic and international financial markets.

He is a member of PNC's Investment Policy committee and is responsible for defining the asset allocations and portfolio strategies used throughout PNC to advise individual and institutional investors. In addition, he is chairman of PNC’s Portfolio Construction committee where he directs the activities to design, monitor and support the various model portfolios utilized throughout the organization. In addition to traditional portfolios, these include PNC’s innovative liquid alternative and smart beta strategies. He is a voting member on PNC’s Investment Advisor Research committee, which oversees manager due diligence, and multiple other governance committees.

Stone joined PNC Wealth Management in 2000, serving most recently as chief investment officer and investment director of the Pittsburgh and Boston markets. In this role, he provided investment leadership in the creation and implementation of investment strategies. Stone's professional experience also includes several positions with Wall Street firms, most notably as financial analyst at Salomon Brothers and institutional sales with Smith Barney. He also served as chief investment officer at First Western Trust.

In addition, he is a popular public speaker and has presented at numerous U.S. and international conferences. He often appears on U.S. and international TV and radio as well as in print media to share his keen insights into the global financial markets. His expertise has been featured on ABC, Bloomberg, Bloomberg Asia, CNBC, CNBC Asia, Fox Business, and NHK World. He has been quoted extensively in the financial press, including The Wall Street Journal, Financial Times, Bloomberg News, Barron’s, USA Today, and The New York Times. He became a contributor to Forbes in 2014. He can be found on social media on twitter: @ewstone.

He previously served on the board of directors of the Economy League of Greater Philadelphia and is a member of the Union League of Philadelphia.

Stone is a cum laude and Honors Program graduate of the University of Dayton with a degree in Finance. He earned a master's degree in Business Administration from the University of Pittsburgh’s Katz Graduate School of Business. He earned the Chartered Financial Analyst® and Chartered Market Technician designations.

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  • Market Events and You

    Consider that publicly traded securities have a quoted price every day, and are subject to the whims of human behavior. Imagine if an investor were to behave reactively with other large assets in possession, such as real estate. Depending on what buyers were willing to offer for a property on any given day, the owner may want to sell just because others decided it was not worth as much as it was the day before. What if no one wanted to buy it? Would that make it worthless or further motivate the homeowner to sell? This is an extreme example — but illustrates the underlying philosophy of why you should not permit market events to determine your decisions.

    Using a Safety Net

    With fluctuations in the marketplace a given, and market dislocations hard to predict, setting aside ample cash reserves is one way to help weather a bear market. Building a reserve that will cover necessary expenses allows retirees to avoid withdrawing funds while their investments are at their weakest; nothing is more harmful than having to sell during down times.

    Investors aim to reduce risk by moving short-term funds to more conservative investments, while maintaining normal allocations with funds marked for later use. But this requires some careful thinking: How much of your portfolio would suffice during a downturn? Would one year’s worth of expenses be enough? Two years’ worth?

    Those who are especially risk-averse might consider holding even larger cash cushions. Since World War II, the average stock market recovery took 24 months to surpass its previous peak. Recent recoveries have taken even longer: The most recent S&P 500 recovery took more than five years; the rebound from the dot-com bust in the early 2000s took almost seven years.

    Bear Market Cash Consideration: How Much Do You Really Need?

    You might think you’re being vigilant by boosting cash reserves to prevent a shortage, but the reverse actually proves true: Withdrawing less means that you’re sustaining your portfolio’s market values, keeping more invested. The key is to maintain normal allocations with the long-term money.

    Imagine a portfolio that suffered a 25% decline — the typical decline experienced by the stock market in the average post-World War II bear market.


    33%

    The amount the portfolio would need to grow to recover

    40%

    The amount the portfolio would need to grow to recover if the retiree withdrew a typical 5% to cover living expenses in such a bear market

    Ill-timed withdrawals only deepen the pit from which a portfolio needs to climb.

    Hedging the Bear

    Hedge funds provide some interesting insight when compared with traditional stock-and-bond portfolio performance during bear markets.

    From October 2007 to February 2009, an investor with a $100 beginning hedge fund investment would have ended up with $78.58.[3]

    $72.90

    Balance if investor had 50% stocks and 50% bonds (Barclays Aggregate)

    $64.88

    Balance if investor had 65% stocks (S&P 500) and 35% bonds (Barclays Aggregate)

    Important Legal Disclosures and Information

    1. Historical Returns and Range of Returns by Asset Allocation Profile, 1926-2015, Ibbotson Associates and PNC.

    2. HFRI Fund Weighted Composite Index versus 50% S&P 500/50% Barclays Aggregate, January 2000 to May 2015. Ibbotson Associates; Morningstar; HFR Asset Management, LLC; Barclays Capital; Standard & Poor’s; PNC

    3. Hedge fund performance as invested in the HFRI (HFRI Fund Weighted Composite Index from HFR® Asset Management, LLC).

    This material is meant to educate and not to provide legal, tax, accounting or investment advice. PNC Investments and its affiliates and vendors do not provide legal, tax or accounting advice.

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