Bear markets are a “when”, not an “if”. The goal is to go into one without being overly aggressively positioned, so you don’t have to sell into a declining market. If you can’t achieve the former, the next best thing is to be able to discern when you are truly in a bear market, as opposed to the far more common short term pullback. Many investors mistake the first 1% drop as the beginning of the next bear market. That is almost always wrong. Markets drop 1% or more frequently. Bear markets are never revealed on Day 1. The subsequent market activity reveals the bear. For example, the last bear market began on October 10, 2007. Investors didn’t really realize a bear market had begun until perhaps June 2008 because stocks had more or less moved sideways from November through May and while financial stocks were clearly signaling distress, other industries (energy for example) had been doing quite well. See Figure 1. In the previous cycle, stocks peaked on March 24, 2000, but the superior performance of real estate and consumer stocks masked the deterioration in the technology sector until late in the year.
Figure 1: S&P 500 August 2006 – September 2009
Stocks have made another very strong run, and investors are understandably worried about getting caught in another bear market that cuts markets averages in half. However, attempts in 2012, 2013, and earlier this year to “call the top” have been unsuccessful because tops don’t happen simply because the market has become expensive. What usually happens is that a long period of higher highs and higher lows gives way to a period where highs are no longer higher – the market cannot meaningfully break above its previous high. Then the declines start making lower lows. Finally, the last rally falls well short of the previous rally high (as if there was simply no buying demand left).
Looking at our current situation, we haven’t had the first lower high yet on any average except the Russell 2000 small company average. Obviously, that bears watching. On the other hand, mid and large company stocks made new highs here in July. I re-iterate my concern regarding the shorter time horizon of today’s investors in comparison to years past. The natural result of a compressed investment horizon means that when the Federal Reserve is forced to remove the punch bowl (so to speak) the market’s reaction could be surprisingly swift and not all that pleasant. That said, neither the Federal Reserve nor the market’s technicals are at this time signaling a change in the bullish paradigm. Therefore, the bulls should continue to be given the benefit of the doubt.
Emerging markets have been the best performing area of the market this month. China reported June economic growth above expectations, India continues to benefit from optimism tied to Modi’s election victory, Indonesia recently completed an election that the market likes, and the frontier markets of the Persian Gulf region and Africa continue to rise (go figure)! Morgan Stanley Frontier Emerging Market Fund (MFMPX) is a solid frontier fund due to an experienced manager, high active share and a tremendous resource base supporting the team. Matthews Asia has a very good India fund (MINDX) with a long track record. T. Rowe Price New Asia fund (PRASX) is worth a look due to the fund’s consistent long term performance and a low expense ratio. I would increase my exposure in these areas at the expense of Europe, which I believe got a cyclical respite after Draghi’s 2012 promise. The problems in Europe have been largely swept under the rug (I don’t mean you Ireland – keep up the good work) and could resurface at almost any time.
I have used the Sequoia Fund (SEQUX) extensively since it temporarily re-opened in the wake of the brutal market decline of 2008. Its long term track record is highly enviable. I know that if I sell out of this fund, it could be another 20 years before it reopens again. That said, I am extremely uncomfortable with its’ 18% position in Valeant Pharmaceuticals, a Canadian pharma firm with an aggressive growth-by-acquisition strategy. Sequoia now reminds me of Fairholme (FAIRX), another non-diversified fund that doesn’t shy away from controversial positions. All of this may be well and good for the speculator, but I am questioning its place in the portfolios of moderate risk investors.
This has been a fairly rough month for high yield bonds. By the end of June yield spreads versus Treasuries had just about reached all-time lows. Many funds were advising reps to continue to buy them because they still yielded well above Treasuries and default rates would likely remain low. The problem with this “picking up pennies in front of the steamroller” approach is that a small reduction in liquidity can wipe out the yield difference. In July investors started to become concerned about the health of the stock rally in light of the Fed’s continuing taper. High quality bonds are “ballast” – they usually move opposite from stocks on economic concerns, so they reduce overall portfolio volatility. High yield bonds, of course, are pro-cyclical. They typically move in the same direction as stocks. The strong performance of higher quality bonds relative to lower quality bonds this year has nothing to do with inflation expectations and everything to do with ballast; there just aren’t many investments with extremely favorable risk/reward ratios left anymore.
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 If it does so, it is by a small amount, or on weaker volume, and fewer stocks are part of the advance.