PMC Weekly Review - January 22, 2016

A Macro View – Embrace the Bear

After being stuck in the narrow 2000 – 2100 range for more than a year, the S&P 500 Index moved decidedly lower to start the new year. As of the close on January 21, it already had plunged 8.5% in less than a three-week span since the start of 2016. In fact, at one point the index was as low as 1812, a level last seen in February 2014, and more than 15% lower than the record high reached in May 2015. Although pundits like to argue the exact technicalities of a bear market, for most investors, if it looks like a bear market, feels like a bear market, and smells like a bear market, well, it’s a bear market.

Granted, the first thing investors should do is to switch their mentality immediately from wealth maximization mode to capital preservation mode—and the earlier, the better. It sounds easy, but after nearly seven years of a long bull market, it may be easier said than done: old habits die hard. For example, buy-on-the-dip has been one of the most rewarding strategies during the past seven years (as well as during other bull markets.) But in this environment, investors should refrain from doing this too often, and be more cautious when they do it.

Stock price movement is also more volatile in bear markets than in bull markets, whether it is on the way down or on the way up. In bull markets, greed is the major sentiment that drives investor behavior. Greed is a relatively mild human emotion-- people want more and more, but not necessarily all at once. As a result, bull markets are generally slow and steady. In bear markets, however, fear is the dominant sentiment that drives investor behavior. Fear is a dramatic human emotion resulting from survival instincts, and investors tend to overreact out of fear of either losing money or missing out on a rally (or both). Thus, bear markets are generally very “violent”, and they have huge price swings. History demonstrates that the most spectacular, short-term market rallies actually take place during bear markets, rather than in bull markets. For investors, keeping it cool during bear markets is more important than in bull markets.

Obsessing over (and hunting for) that elusive bear market bottom is a fool’s errand. Except for con artists like Bernie Madoff, no one can catch bear market bottoms consistently, as the odds of succeeding (unless one is faking records) are only slightly better than hitting a billion-dollar lottery. Rather, investors should focus on their risk exposures, liquidity needs, and long-term goals.

Bear markets are scary, but in a structurally-sound equity market, such as U.S. equities, they are generally much shorter and shallower than bull markets. Case in point:  suppose an investor had stayed put since the end of 2007, and suffered a whopping 37% investment loss in the S&P 500 Index in 2008 (the S&P 500 Index lost 37% in 2008). Just two years later, that investor would have recouped over 90% of the losses (the S&P 500 Index gained 26% in 2009 and 15% in 2010), and would have recovered all of the losses by April 2011, by doing nothing other than continuing to stay put. For strategic investors with a long-term horizon, bear markets are part of the journey—they are really nothing to fear. Simply embrace and deal with them.

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