How to Prepare for the Next Bear Market

Let’s face it, there will be another bear market. It might start tomorrow or it might not start for several years but over time, bear markets inevitably follow bull markets.

The inevitability of a bear market can, and often does, influence an investor’s outlook on the market. This impact ranges from a tendency to ignore the risks to a tendency to be paralyzed by the risks.

Ignoring the risks allow investors to invest aggressively. If we think back to the Internet bubble, we have a perfect example of this behavior. The table below shows the return of the S&P 500 for a few years in the 1990s.

A simple buy and hold strategy in an index fund would have turned $1,000 into $3,475, a total return of 248% in five years.

With a gain like that, some investors seemed to believe the market would never go down and we began hearing a new era in the economy where the Internet was changing everything. More aggressive investors believed that if an index fund could double their money in less than three years, an active trading strategy based on Internet stocks could allow them to double their money in months or even weeks.

In hindsight, we know that investors who ignored the risks suffered deep losses in the crash that followed these exceptional years.

We also know that crash and the bear market that began in 2008 increased the level of fear among many investors. As prices fell in the stock market, many investors sell. They increase their cash holding and many seem not to realize the decision to increase cash requires a second and equally important decision about when to reinvest.

Some investors never consider the second decision and wait for a safe time to re-enter the stock market. They usually refrain from buying while stocks are falling. After stocks bottom, the initial phase of a bull market often includes rapid, large gains. They hold back from buying then because they believe this is a bear market rally. Then there is a pullback, maybe after stocks have gained more than 40% as we saw in 2009. But, some investors worry that the pullback is actually a resumption of the bear market and they stay on the sidelines.

This pattern can continue as fear leads to an inability to make a decision to get back into stocks. The result is sometimes that an investor suffers steep losses in a bear market and then misses out on many of the gains of the bull market.

Because of the nature of bear markets, there are some steps investors can take to prepare for them.

One step to take is to remember that bear markets are normal, inevitable and unexpected. By unexpected, we mean that the start of the bear market is impossible to predict in advance. Likewise, the size of the down turn and the day the bear market will end are impossible to predict in advance. Successful investors often accept the reality that a bear market will occur in the future and they will suffer some losses when that happens.

Rather than worrying about the bear market, successful investors plan for it.

There are several ways to plan for the bear market. One way is to have a market timing strategy in place. Perhaps they plan to increase their cash position when the price of the S&P 500 closes below its 10-month moving average and become fully invested after prices rise back above that average. Other investors use a diversified portfolio to prepare for the worst and benefit from bull markets as long as they last.

One way to diversify a portfolio is to add different asset classes to your holdings. Different asset classes include bonds, gold and other investments that have historically shown little correlation with the stock market.

Diversification through asset allocation is a problem that has been well studied because this is an approach many institutional investors have adopted. Many large college endowment funds use this model to reduce their losses in a bear market.

According to one recent study, gold and master limited partnerships (MLPs) are among the best asset classes to use to limit the pain of a bear market.

Gold can be thought of as similar to cash in some ways since both cash and gold are intended to serve as a store of value. Gold has historically been viewed as a way to protect capital against inflation, since the gold is expected to retain its value as cash loses purchasing power during times of high inflation. Gold is also viewed as protection against economic catastrophe since if you own gold, it can be used even if the legal system completely breaks down.

While gold could provide a means of transacting business even after a nuclear war, the downside to investing in gold is that it loses value during periods of deflation and is also subject to short term price swings related to speculative price action in the futures markets.

In a portfolio, this means gold is expected to outperform during inflationary periods and history shows it has when inflation increased during the 1970s and even when inflation was relatively mild but increasing in the early 2000s.

But, gold underperforms during periods of price stability and high interest rates such as the 20-year period from 1982 to 2002. Gold also underperforms during deflationary periods, when inflation is falling or even negative, like we recently experienced with the commodities deflation that unfolded from 2011 to 2015.

Remember that diversification reduces portfolio volatility in the long run. Gold does this even though day to day there are times when gold underperforms stocks.

Master limited partnerships are publicly traded partnerships, which are unique in their tax treatment as “pass through entities.” This preferred tax treatment shields most of the partnership income from federal taxation and generally provides high yields to investors.

An important feature of the MLP return profile is associated with those yields and cash flows. Typical partnership agreements require MLPs to distribute all of their available cash flow to shareholders. This has made MLPs a popular income investment in recent years, thanks to their relatively high yields in a low-rate environment.

MLPs have a long history with the first one being launched by an oil and gas company in 1981. While the MLP structure has expanded into other sectors, including telecommunications utilities, over the years, the original formation of MLPs was focused on the oil and gas sector and this remains largely the case in the current market.

Because of their association with the energy sector, MLP performance is closely correlated with the current price, and the rate of change in the price, of crude oil. This makes MLPs a potential source of inflation protection within a portfolio.

This explains why MLPs can diversify a portfolio. Like gold they track commodity prices. Unlike gold, they offer income. MLPs generally outperform during inflationary periods with rising oil and gas prices and underperform during deflationary periods with falling oil and gas prices.

MLPs followed the sharp price declines in energy markets over the last couple of years, but have since recovered alongside the recent recovery and stabilization in crude oil prices. Now, MLPs appear poised to deliver a potential hedge against a return to inflation in the future.

When the next bear market comes, and we do know there will eventually be another bear market, these asset classes could deliver potential gains has they have in the past. Diversification could be among the best defenses against bear market losses and in diversifying, investors are following the lead of many large institutional investors.