FSO Editorials: Bear Market Investing for the Long Term by Robert B. Gordon 09/28/2003

Bear Market Investing for the Long Term
by Robert B. Gordon, Sc. D.
September 28, 2003

As we write this essay, the eleven month bear market rally appears to have ended and the next major down leg started. This could very well be the last chance for anyone still holding their old bull market stocks and funds to take major corrective action. It is possible for any of my readers to use the information in this and previous essays to switch from assets designed for bull markets to those which have shown promise in the bear market to date. Please note that, because of the limited amounts of some favored asset classes, individuals have an advantage not available to large institutions. This is the time for those with the necessary information to put it into use as it may be the last and best opportunity.

I have been convinced since 1995 that the bull market mania in stocks would be followed by a depression of greater length and depth than that after either the 1929 Crash or the still on-going 14 year old depression in Japan. I have given all the details and background in numerous essays over the past two years. This essay will give my best thoughts on growing assets in a very difficult environment. There is no need to wait for more evidence since my retrospective portfolios have done well since the bear market started over 3 years ago. And, if that is not enough to convince you, then run a bear portfolio versus any other you wish to use.

Very few individuals, or corporate and government leaders, are preparing for a very long and brutally severe bear market. Most individuals are bullish and many are largely unaffected by the bear market to date. Corporations and states are borrowing money to balance their budgets and cover losses in their pension assets, all moves that will hurt them in coming years.

Individual investors with the right information can build assets in ways not open to large institutions. But investors who are dependent on conventional brokers and advisors will never learn about them. Traditionally, pension funds, insurance company reserves and other large pools of money are invested in a fixed ratio of stocks and bonds, say 60% stocks and 40% bonds. In periods like the present, with both of these asset classes in a bear market, managers of these funds have no good alternatives. They are grasping at straws by placing small amounts in risky hedge funds. One state has been advised to buy junk bonds to improve its pension fund performance, a good example of the blind leading the blind.

Billion dollar mutual funds, of which there are many, have somewhat similar problems if they must follow a prescribed asset mix. As the bear market nears the end of its fourth year, most mutual funds are still flying high on the wings of the long bear market rally. Several major fund companies are being charged with serious abuses of their client’s funds. My long held view, based on my1972-74 bear market experience, is that many funds will disappear, by closure, merger or legal action in the current bear market. Broker’s are now being penalized for paying extra compensation on their in-house loaded funds. What scandal will be next for this troubled industry?

If individual investors haven’t learned it by now, they surely will in the next bear leg down. The stocks and mutual funds that were winners in the bull market will be losers, not winners, in the long bear market ahead. Reason 1 is that, in bear markets, most all stocks drop in price in line with a very depressed economy. Reason 2 is that investors demand better dividends or a lower Price/Earnings ratio. These conditions are those found only when the market reaches a real bottom.

Usually a few equity classes like precious metals or natural resources will buck the main market trend, but they cannot take trillions of dollars of new money. This limited supply also applies to mutual funds that hold large short positions to provide gains when the general market is going down. The usual gimmicks that mutual funds use to sell their wares, like promoting small caps, large caps, equity-income or international stocks will not buck the general trend of a bear market. When bonds are falling along with stocks, investors seeking income have very few options. Bear markets like this one occur with much lower earnings from corporations, so income dividends are low. The surest way to grow capital or obtain income is to periodically take capital gains from asset classes rising in price. This requires a major change in thinking for investors seeking income. Bonds are dropping in price, making it necessary to use short term bond funds or bonds held to maturity. And bond quality is usually dropping in weak economies, requiring constant monitoring of bond holdings. With the huge budget deficits in most states, there will no doubt be some issues of tax-free bonds that will default on their interest payments which will be bad news for conservative bond holders.

Please read this timely warning. I now fully realize the tremendous need for this essay. Multiply $58,000 by millions of investors and it adds up to trillions of dollars at serious risk in the remaining years of this great bear market. Individual investors are in the same danger as the institutions, but they, as individuals have the chance to change their holdings and save their retirement assets. Please send copies of this essay to your family and friends so they can escape huge losses.

"Warnings about the possible overvaluation of U.S. equities and the potential for rising interest rates could mean it's time to consider alternatives to what have traditionally been the 401(k) investments of choice.

It's not surprising that 401(k) investors are currently so heavily invested in U.S. stocks and bonds, given that 401(k) plans came on the scene in 1981 - the very beginning of the strongest bull market in history and an extended period of falling interest rates.

In fact, according to the Employee Benefit Research Institute, the average 401(k) account balance, approximately $58,000, is invested 62% in U.S. stocks and nearly 30% in U.S. bonds and guaranteed vehicles.

Past successes do not make this strategy right for the future, especially given the increased chance that U.S. stocks and bonds could under perform for an extended period.

In January 1966, the U.S. stock market, as measured by the Dow Jones Industrial Average, peaked at 1001 and didn't move significantly higher until December 1982. During this 16-year period, an index fund would have gained no ground and would have lost significant value when adjusted for inflation. During this same period, interest rates rose from 5% to 14%, as measured by 10-year Treasury yields, making bonds an even worse option.

As an investor, your challenge is to stop fixating on past performance and start considering the best place to be in the future. The question then becomes, where are the best places to put your money?"

I sincerely hope that all readers currently adding to their retirement plans, will seriously consider following a new course. If withdrawing and starting over is not possible, please think very seriously about starting a new program designed to build capital in the assets your old plan is lacking. This would mean adding large amounts of short positions, natural resources and precious metals.

My guess is that individual investors, armed with the right knowledge, will outperform others who are dependent on conventional thinking. Regardless of their age, investors who have been investing for retirement in IRA’s or 401K’s will have to think the unthinkable and change their investing practices. If their retirement plans do not have the right asset classes for a bear market environment, the best thing to do may be to pay any penalty and withdraw the funds. This will be a very difficult choice but is probably a best option for many investors.

It is fair to assume that the great majority of people who are currently trying to grow assets for retirement have never created and managed a personal plan aimed at a definite goal. In this essay we will address this problem by suggesting how to start simply and then add more asset classes necessary to achieve the ultimate goal.

The first step in creating a workable plan is to be realistic in setting a desired rate of return. Setting a double digit rate of return for a portfolio to catch up for past losses may be completely impractical. Whether, they realize it now or later, no serious investor can afford to gamble with their retirement nest egg. If a reasonable rate of return will not do the job, the alternative is a stringent savings plan to lower the family cost of living.

To review several recent essays, there are only a few major asset classes which appear to be attractive in a long bear market: Short term bond funds of highest quality, short mutual funds, precious metals and other natural resource stocks. The bonds are considered to be the core holding of at least 50% and will have the smallest price oscillations. The other 3 classes are much more volatile, a characteristic which we use to take consistent small profits thru a periodic portfolio rebalancing process. More about this later.

The highest quality bonds are those of a sovereign nation such as the U.S. and other major countries of the world which are considered to be the highest quality available. Along with other experts, we recommend splitting the bond class into equal amounts of U.S. and foreign debt to guard against any further loss in the value of the dollar as is now occurring.

Our plan, not only takes advantage of profit opportunities in the 4 major asset classes but in larger portfolios, uses two or more sub classes in the short funds, precious metals and natural resource asset classes. So, for small portfolios, we start with just 4 funds in 4 asset classes but large portfolios can profitably use 10 or12 sub asset classes. Each time another qualified asset class is added, portfolios gain another way to produce more capital gains.

Investors are accustomed to receive short and long term capital gains from mutual funds they own but they may not be accustomed to taking them periodically from portfolios they manage. on their own. Since this is one of the few ways to lock in temporary growth in a multi-asset portfolio, we will go over it again so readers will be sure of its purpose and great value to a bear market portfolio.

By using at least 50% of short term bonds, the portfolio gains two things: (!) a conservative place to receive and protect capital gains earned in other volatile asset classes and (2) a "bank" from which to transfer capital to other lagging asset classes during the rebalancing actions. There is nothing more to add other than to emphasize the simplicity of this type of portfolio structure and the fact that paper studies have worked very well over the bear market to date.

Later, we will explain how some investors in some types of brokerage accounts can do the required rebalancing operations in an almost effortless manner with just simple calculations.

But regardless of how each investor chooses to implement their bear market portfolio, it must be based on a planned program of periodic taking and saving capital gains versus the usual buy and hold accumulation plan. This heavily advertised program might work in some types of bull markets but could be disastrous in a severe bear market.

This portfolio features 8 asset classes, each with its own price action, to capture significant amounts of capital gains over the duration of the bear market and two conservative bond funds to receive capital gains from, and provide assets to, the other classes that may be lagging the others. The short funds will be lagging in each general rally in stock or bonds. Money added to them will become capital gains when the bear trend resumes The 3 precious metals classes will almost surely produce a large percent of the gains due to their high volatility and as shown in our retrospective studies. The energy and timber classes may lag early on but will do well over the long term. For portfolio sizes over $100,000, I would be inclined to add a silver mining stock and split up the energy category into two or three distinct stocks, e.g. oil, gas and coal.

Short U. S. Treasury Bond Fund	26%
Short Foreign Govt. Bond Fund	26%
Reverse Index S&) 500 Short Fund	6%
Reverse Index NASDAQ Short Fund	6%
RYJUX 30-Year Bond Short Fund	6%
ASA Closed End Gold Fund`	6%
CEF Closed End Bullion Fund	6%
Selected Open End Gold Fund	6%
Diversified Coal, Gas, Oil Fund	6%
PCL S&P Timber REIT Stock	6%
Total	100%

For the three year period ending September 24, 2003, here are the weighted annualized returns for each of the four major asset classes. This excellent return involved one choice for the ten securities and a single calculation from my FastTrack Computer screen. There was no attempt to make the data look good. Our goal has always been to provide a representative portfolio that can be duplicated rather closely.

No. Assets	Asset Class	Actual	Plan
2	Government Bonds	5.31%	6.04%
3	Short Funds	1.14	2.10
3	Precious Metals	4.44	2.10
2	Natural Resources	0.75	1.40
10	Total Annualized Return	11.64%	11.64%

Note, first of all, that all four asset classes showed gains. All of the actual gains in this 3 year period, above the plan, were furnished by the 18% precious metals sector. The short funds were at the top of a bear market rally this month and it would be very desirable to rebalance right now with funds going from precious metals to all 3 other sectors. As explained in this and other essays, this rebalancing will of course help build future profits.

I’m sure that our regular readers know very well that the future is uncertain and that there can be no estimate or guarantee of future returns. However, this portfolio gains credibility from its broad choice of asset classes and its very conservative core bond position. Future profits from the volatile asset classes are unknown in quantity but, when they do occur, they will be saved and reallocated to the bond funds or to any lagging classes thru the rebalancing process.

Short Term US Treasury Bonds	40%
Short Term Foreign Govt. Bonds	40%
Reverse Index S&P 500 Short Fund	10%
RYJUX 30 Year Bond Short Fund	10%
Total	100%

This modest portfolio would grow during bear market down moves in both stocks and bonds. Then, the gains in the short funds should be transferred for safe keeping to the bond funds. The rebalancing dates should ideally be done at market lows for maximum portfolio gains,. Then, as funds become available or as confidence is gained, more capital and other asset classes could be added.

Of course, investors can choose to start with any number of asset classes. I have suggested above the possible addition of 3 more classes to the 10 asset portfolio, each "marching to a different drum beat". Do not ever think of our portfolios as being complex or requiring a lot of management time. If you cannot believe it at the start, begin with 4 or 6 asset classes and you will soon see how simple this concept really is.

We have an unknown number of readers who may never have had an on-line brokerage account. In our view, this is desirable for reasons of both cost and convenience. There are a number of discount brokers whose commissions to buy or sell a stock or fund are less than $10 and one that advertises a $5 commission. Many such brokers will buy and sell no-load mutual funds at no cost provided they are held for a number of months. I suggest that interested readers should phone ten brokers who advertise widely and ask for their commission card.

In my recent tutorial essay on portfolio rebalancing, I gave the full details on how the rebalancing calculations are done. But if you are in a tax-free discount brokerage account, you may be able to greatly simplify the process at reasonable cost. Consider this example:

Now, I agree that the above process looks a bit ridiculous except for one important point. Our experience shows there is a real advantage in rebalancing at the high and low values during any year. If you do not have the ability to view high and low portfolio values on a computer screen, the next best thing is probably to write down the daily or weekly prices. Of course, if this portfolio includes no other securities, all you need to record is the total value.

In the difficult times ahead, many banks, insurance companies and brokerages may fail. It is good to know that anyone can go to www.weissratings.com and for $7.95 obtain their latest quarterly A to F rating. I suggest you get in the habit of checking those institutions holding your assets.

When things get really tough, and by that I mean much tougher than we have seen yet, you have got to put your trust and your assets in a portfolio structure having these features:

Readers have many options. They can start with a small portfolio and build it to any size they may desire. But in my experience you must have at least half of the portfolio in very safe bonds. If you wish to own more gold or short funds, for example, please do it in a separate portfolio.

Although there can be no guarantees for the future, what you do with these suggestions is entirely up to you. The full 10 asset class portfolio is easily set up and managed. I am in the process of building one in my on-line IRA account to help me answer any questions in the future from my readers. I do not intend to report on its performance because my present life expectancy is probably about 2 years vs. twenty to fifty years for my readers.

Please do not try and add any complexities to what is a very simple portfolio. Do not worry too much about selecting the best stock or fund for a particular asset class. The ones you start with can be replaced anytime you find a better one. In the long term, there will almost certainly be replacements. Choose mutual funds from strong no load companies you expect to still be in business ten or twenty years from now. Start studying the growing list of exchange traded funds (ETFs) which may prove to be better than present open end funds.

Go to Bloomberg, Yahoo and Morningstar web pages for data to help in picking no load mutual funds. In past essays, we have listed performance data for foreign government bond funds, short funds and gold funds. These will give you names of funds for further study.

We are now at the start of a major down leg in the market. It will not go straight down but have intermittent rallies, each of which has the capability to provide capital gains via regular rebalancing. Please take action to protect your invested capital. Good luck to all.