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Bear Market Learning Portfolios
A Tutorial for Thinking Investors

by Robert B. Gordon, Sc. D.
February 10, 2003

This great bear market is in an early stage and there is plenty of time for investors to learn how to build and conserve assets under difficult conditions. Readers are encouraged to consider seriously the unconventional approach  presented below for serious long-term investors.

Over the past year, in many essays, I have stressed two important points:(1) nearly all equity classes that did well in the bull market will drop sharply in price and (2) only a very few unconventional assets will do well in this severe bear market. I have previously published many examples that demonstrate how to build and manage a successful, balanced portfolio. But, judging from many e-mails, I have failed to adequately convey my message to readers.

I probably spend more time reading and responding to e-mails that I do writing my essays. Nearly all letters are highly complimentary, but many are accompanied by questions that clearly show they do not understand and are not following my general advice. In a recent case a reader asked me to comment on his being 90% in gold and 10% in cash. It was hard for me to phrase a response since that "portfolio" was so far from any of my suggestions.

My long-time readers know that I did not acquire my investing skills by reading books or following conventional advice of others. I learned in the market place by trial and error, by making mistakes and correcting them. And for most of the time I lacked all of the modern tools available now in the computer and internet age. I have spent more time calculating moving price averages by hand as a market timing tool than I care to remember.

When I get e-mails from people who obviously need more help, I ask them to read my old essays in the www.freebuck.com's Commentary archives. In addition, I have decided to try once more to spell out as plainly as possible that investors, old and new, should drop their old bull market ideas and start to build a new and successful approach to bear market investing.

SUCCESSFUL BEAR MARKET INVESTING

Warren Buffett gave us the best two rules for most economic conditions:

"No.1  Don’t Lose and No. 2  Don’t forget Rule 1."

However, in a "once in a century" bear market, a better guide is to avoid conventional asset classes like most stocks and bonds that the institutional investors are forced to own due to their great size.

Individual investors capable of thinking for themselves, are able to use asset classes like precious metals and short funds, available in fairly small quantities. They are not available in sufficient quantities to interest most stock brokers who are preoccupied with their major task of peddling stocks and bonds. In fact, a broker in California wrote recently about his disgust that his major firm ordered him not to sell a "negative" vehicle like a bear fund.

It is very important not to place all your money in any one or two asset classes just because they have the best chance of going up in price over time. Gold and silver have had a very volatile price history over the past twenty years. And short funds, as I have learned over the past five years, must be handled with great care to gain their important benefits without too much loss of sleep.

For the past year, in every essay providing examples of bear market portfolios, we have suggested a conservative approach employing all our favored asset classes and as great a diversification as possible through the use of available sub classes. For all of our readers, both new and old, this essay will provide  two learning portfolios which are intended to teach investors the art of bear market investing. These learning portfolios can grow to any desired size once the investor has gained enough experience to understand (1) how each asset class performs in normal up and down market cycles and (2) how to rebalance assets periodically to assure long term success.

ELLIOTT WAVE MARKET PREDICTION

We are now in the first down wave of Grand SuperCycle Wave IV. This is the second corrective wave in the five wave series that started centuries ago. Three hundred years of history show that the most common form for a fourth wave is an extended horizontal triangle with repeated price movements between an upper and lower level. The last example of this behavior was at a lower wave level and occurred between 1966 and 1982  when the Dow was in a so-called "trading range" pattern between roughly 500 and 1000. This very real bear market was completely hidden by the massive double digit inflation then occurring. But, corrected for inflation, the market dropped 74% - our second greatest bear loss.

In his recent publications, Robert Prechter has shown his concept for the current bear market.  It is a greatly enlarged version of the 1966-82 trading range with the price swinging widely over the rest of this century between a very low level and a much higher level which, at the time, will be viewed as huge new bull and bear markets. If this occurs, even in part, it will completely baffle all non-Elliotticians.

I present the above picture to give you a small idea of the uncertainties that lie ahead.  Only the very youngest of my readers will be alive to watch the full bear market pattern develop. The main point I wish to make is the possibility that this bear market will not go straight down to its final end. My conclusion from this is that any portfolio constructed now should be designed to eventually contain ALL attractive asset classes and each of their sub classes. Then, this long-term portfolio should be managed to take advantage of individual price cycles that will surely occur both WITHIN each asset class and BETWEEN the major asset classes. Please note well our later remarks on portfolio rebalancing.

I have written extensively on both selecting and managing assets for bear market portfolios. Go to my archive at www.freebuck.com and read my prior essays. In this essay I will stress how an investor can plan, assemble and manage a starting portfolio that can grow into a much larger permanent portfolio by making changes as the need for them develops.

SELECTING ASSETS FOR THIS BEAR MARKET

To prepare for a long and difficult investment scene, we have to throw out all outdated concepts from the bull market. We have to stress real tangible values and techniques to conserve our principal.  We need to build in the ability to "roll with the punches" and deal with future adversity that may arise. Here is the list of asset classes and sub classes that we prefer based on current knowledge

First,  we are going to suggest two starting portfolios that use some or all of these asset categories.  We will follow with their historic performance over the 3 year bear market to date.

A MINIMUM STARTING PORTFOLIO

Assuming a tax sheltered program permitting $1000 minimum fund investments, we propose starting with the following portfolio:

                    $1000 - ASA closed end gold fund traded on the NYSE
                      1000 - BEARX fully managed short fund
                      1500 - U.S. Treasury Short/Med. Bond Fund
                      1500 - Foreign Govt. Short/Med. Bond Fund
                   $ 5000   Total

We specifically name ASA and BEARX because they are the only funds of their kind.  We like ASA, a unique closed end gold fund, because it has a fixed amount of capital and will not be deluged with new dollars when the public gold boom begins. Large gold funds cannot buy meaningful amounts of the best gold stocks and should not be held. BEARX is unique because it holds about 20% gold stocks in addition to its short positions. In contrast, there are quite a few U.S. mutual fund families that offer the specified bond funds.  For information on foreign funds, see our essay "Selecting Foreign Government Bond Funds". We specify equal dollars for the bond funds to fully hedge against a fall in the U.S. dollar. With its roughly 20%, 20%, 60% asset distribution, this fund will serve as an excellent start for both new and old investors. We will add suggestions later on how to manage and expand this portfolio.

A BROADER STARTING PORTFOLIO

We expand our first portfolio by using one representative of all ten suggested asset classes:

              $1000 - ASA closed end gold fund traded on the NYSE
                1000 - CEF closed end gold and silver bullion fund traded on 
                            the AMEX
                1000 - Medium size, unhedged gold mining stock
                1000 - BEARX fully managed short fund
                1000 - reverse S & P 500 index short fund
                1000 - reverse NASDAQ index short fund
                1000 - Energy mutual fund
                1000 - PCL - unique timberland REIT traded on the NYSE 
                1000 - U.S. Treasury Short/Med. Bond fund
                1000 - Foreign Govt.     "       "         "       "
                5000 - U.S. Treasury MM fund 
            $15,000  Total

Please note the total precious metals and short percentage remains at 20%, as in the smaller portfolio, and we have taken 13.3% from the bond and MM allocation to fund the natural resource category. CEF, like ASA, is a very unusual fund, holding only gold and silver bullion in a large bank vault. There are a number of fine energy mutual funds to choose from. PCL is a unique stock, paying high dividends, that was just added to the S&P 500 index. For more information, read my essay "Choosing the Right REIT’s." What we have working for us is a ten-component portfolio with a good supply of cash to use for rebalancing future price fluctuations occurring in the volatile asset classes.

We recommend this as a great starting portfolio. Over the next two years, an investor holding this portfolio will enjoy a wonderful learning experience. There are almost certain to be some important price variations between both the major asset classes and their sub classes. We do not suggest that anyone should put all their assets in this portfolio, but we have seen reader portfolios that are infinitely worse. In our experience, any bear market portfolio with less than 60% of short bonds and cash should be considered as aggressive, not conservative.

WHY BROAD  DIVERSIFICATION IS HIGHLY DESIRABLE

Diversification is extremely important in any portfolio that may eventually hold your life’s savings. Above a certain minimum dollar amount, broad diversification should be unrelated to the total assets involved. A $100,000 portfolio needs as much as a $1,000,000 portfolio.  Why is this important? In a bull market, with most equities participating, it is not so important. In a bear market, traders are alternately buying and selling any asset class with a profit potential. Fortunately, knowledgeable conservative investors can take advantage of these frenzied actions of profit-seeking traders by following a planned rebalancing program among all attractive asset classes.  Note this well, because you will probably never read it elsewhere.

The future of this long and difficult bear market is completely unknown, despite anyone’s claims to the contrary.  So far, the bear market has broken all previous records for volatility.  Our $15,000 portfolio will not only be a great learning experience, but can lead to a  plan for successful life-long investing.

Our two learning portfolios are not intended to be held for passive buy-and-hold investing. For best results, they should be managed, initially with quarterly or semi-annual rebalancing, either by shifting existing assets or adding new cash. This is where the learning comes in. You are forced to see which sectors are gaining and which are losing. Rebalancing serves to shift money from the winners during any period to the losers or those that did not perform as well. With volatile components, in the next time period the roles of winner and loser may well be reversed.

In the suggested $15,000 portfolio, we have not exhausted all of the desirable sub asset classes. In a permanent portfolio of sufficient size, we would add two more asset classes for best results over an investor’s lifetime: (1) in the precious metal class, a mining stock which is primarily a producer of silver rather than gold and (2) in the resource class, a stock holding large tracts of raw land priced at the original cost of a few dollars an acre. There are large companies owning such land in Hawaii, California, Texas and Florida which will eventually be priced into their common stocks during some future market rally. Please do not ask for their names.  Enjoy the fun of finding them.

SETTING UP AND MANAGING A BEAR PORTFOLIO

We have been buying, selling and managing stocks and mutual funds for more than fifty years. Our experience with gold and silver goes back 30 years and for short funds it started five years ago, before the market top. During most of this period, we didn’t enjoy the computer facilities now available to ease the job of an investor. For some open end funds, we choose to buy direct from the fund when the fund does not limit the number of trades per year. If the fund does have restrictions, we buy from a large discount broker.

Please do not be concerned about the tax consequences of selling portions of any stock or fund. Any part of a "buy and hold" philosophy should be abandoned in a severe bear market. With conservation of capital a necessity, one must always be prepared to get out of any losing position. With carefully selected assets, selling a full position should be a rare occurrence but shifting assets for rebalancing will improve, not hurt, the final results. But the greatest reward from rebalancing is the sense of control the investor gains over the portfolio, not to mention the peace of mind in volatile periods.

There is a considerable advantage in less paperwork and time in using an on-line discount broker. If I were to start the $15,000 portfolio, I would prefer one of several on-line brokers who could offer all of the stocks and funds suggested at minimum cost and inconvenience. This would be perhaps the only practical way you could readily shift small amounts of money in re-balancing. In both of the portfolios I would suggest that, at least initially, the rebalancing be done by adding new cash to the assets with less than the desired percentage.

For those readers wishing to start with larger dollar amounts, I recommend that they read my previous essays on bear portfolios for help in choosing the best ratio between aggressive and conservative asset classes for your risk tolerance.  In the ranges I have previously suggested, both the $5,000 and $15,000 portfolios would be considered quite aggressive.  For example, a conservative portfolio might have 80% bonds and 10% each of gold and short funds.  A moderate portfolio might hold 70% bonds and 15% gold and short positions.  An aggressive portfolio might hold 60% bonds and 20% gold and short positions.  Against these standards, both the $5,000 and $15,000 portfolios are considered as aggressive - fine for learning with a small part of your assets but something to consider carefully when dealing with larger amounts.

BEAR MARKET PERFORMANCE DATA

Here is the performance data for the eleven asset classes used in the starting portfolios:

DISCUSSION

I urge readers viewing the above table not to rush out and buy a lot of gold and short funds. The price charts over these last three years, show numerous sharp, and deep price declines. These turned out, as expected, to be great times to rebalance and shift money from the bond and MM funds.  But many less experienced investors would have panicked and sold out. We are trying to teach our readers to begin a balanced plan that can survive the ups and down and provide growth with safety over many years ahead.

Please note the comparison of the two bond funds over the three year period as the dollar began its decline. This why we do not suggest just one bond fund for the unknown future. Also note the wide performance difference between the 3 gold asset classes which can lead to large gains from planned rebalancing.  An uninformed investor following tips would probably load up with low priced gold stocks which might lead to huge losses. By shifting the gold assets between the 3 classes of widely different volatility, we periodically transfer profits from the most volatile class to the least volatile class (and we sleep well at night while doing it).

Readers may well ask, why do you include those poorly acting resource classes? The simple answer is to make money when the other classes run out of buyers.  The underground fuel reserves are not being replenished and are vital to our society.  Timber is the only resource that grows while you and the market sleep. When these assets are doing poorly, we shift profits into them from the winners and help build future profits. These are tangible, physical assets and totally unlike the stock of a typical NYSE company.  Remember Enron and Global Crossing and others to come.  Basic resource stocks will do well in the long run for investors willing to stick to a sound long term plan.

PERFORMANCE OF THE STARTING PORTFOLIOS

Using the data above and the asset percentages as previously given, the $5,000 and $15,000 portfolios would have provided the following results:

                                   Annualized Gain for Period to 2/4/2003
        Portfolio                 3 Years          2 Years           1 Year

         $5,000                   19.5%            27.1%             39.3%    

       $15,000                   17.4               28.9                 26.8

These results are of course for buying and holding each portfolio for the time period indicated.  We do not recommend this for two important reasons. First, as mentioned earlier, these learning portfolios have higher percentages of volatile gold and short funds than we feel appropriate for the permanent portfolio of most investors. We used these higher percentages for a good purpose, first, to enhance the learning process. Second, and even more important, these higher percentages will more quickly demonstrate the considerable advantages of portfolio rebalancing, a simple process we have been recommending in many essays.

PORTFOLIO REBALANCING

In overall importance to the success of a bear market portfolio, asset selection is more important at first but, eventually, rebalancing assumes at least equal credit for long range success.  Balancing is very simple in concept and in execution. It simply means that periodically, the portfolio is returned to its original composition. At each chosen calendar interval or market event, take the new total dollar value and reallocate it to each asset category in the original planned percentage

There are two ways to rebalance a multi-asset portfolio, at regular calendar intervals or at the price peaks and valleys of the volatile components. Since the gold and short funds "march to different drummers", their price peaks occur at different times.  The short fund prices reach their peak at every low in the market indices which have been occurring several times a year in this bear market.  The gold funds, on the other hand, had only one price peak in the spring of 2002.  But if Robert Prechter’s Elliott Wave count is correct, they may be due for another one soon.

Based on my experience in the last several years, I suggest that frequent calendar rebalancing be adopted initially in a learning portfolio. Later, as more experience is gained, investors with access to daily price charts might wish to try portfolio rebalancing at important tops and bottoms. It is clearly more effective to switch profits at the best time and is an excellent way to obtain consistent growth in a permanent portfolio.

Over periods like two or three years, calendar rebalancing may or may not improve the total performance. It all depends on how well the dates matched important price tops and bottoms. Our guess is that, over periods like ten or twenty years, the gains will be significant. In short periods, using balancing at tops and bottoms in our charts, we have seen large gains in performance over a buy-and-hold portfolio.

FINAL NOTE

As in many previous essays, my emphasis has been on ASSET classes and not on the individual stocks and funds. It is the asset classes that make or break a portfolio’s success. In addition, I feel strongly that, when investors select the specific stock or fund for most asset classes, it then becomes THEIR portfolio and not MINE.  They then assume responsibility for managing and making the portfolio a success.  So, although I have given you some names, it is in your own long-term best interest to pick the others yourself.  Please do not request any names not given here.  Follow the current broker’s ad that advises "Investigate Before You Invest!" Go to web sites such as Yahoo, Morningstar or Quicken for suggestions.

In our considered judgment, these learning portfolios should not employ all or most of your available capital. Modify them to suit your circumstances and always maintain an adequate level of cash reserves. Remember, that this will be a long bear market, so be patient. To fully realize the benefits of broad asset allocation and rebalancing, it will take several years and some violent market swings to enhance your learning process. We wish readers the very best of success!

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© 2003 Robert B. Gordon, Sc. D.
Visit FSO's Cover Page for more editorials by Dr. Gordon

Robert B. Gordon, Sc. D.
Sun City West, Arizona
February 10, 2003
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