How to prepare for a bear market (just in case)

At the time of writing, the FTSE All-Share index stands as 3,235, down 16% from its April 2015 high of 3,834, right on the brink of ‘bear market’ territory, which is defined as a fall of 20% from the top.

While this may not sound like fun, it could be worse. China, Germany, Italy, Russia, Brazil, Hong Kong and America’s leading small-cap index, the Russell 2000, are already in bear territory. Sweden, France and Japan, like the UK, are not far away.

Nor are such declines unusual (unfortunately). There have already been 10 UK equity bear markets since the inception of the FTSE All-Share in 1962, so there tends to be one every four or five years.

The last one was 2007-2009 so history buffs would argue we are overdue one, even if the past is no guarantee for the future. If we do get one – and it remains an if, at least for now – then investors might like to know that the average UK bear market has lasted 385 days and seen the FTSE All-Share fall by an average of 37%.

There have been 10 bear equity markets in the UK since 1962

Source: Thomson Reuters Datastream

If we do drop into bear territory, there is a chance that the market could fall further, although the dips of 1979 and 1981 came to no more than 22%, so again, history is no guarantee of a repeat.

However, investing is as much about managing risk and protecting the downside as it is about seeking out gains to harvest the upside. As such, advisers and clients must at least think about a worst-case scenario, so they are prepared for it, and hopefully suitably protected. As legendary US investor Warren Buffett once put it, “It is madness to risk losing what you need in pursuing what you simply desire.”

To guard against losing what is needed, clients should check to make sure their portfolio is suitably diversified and they are not taking more risk than they perhaps realise. No-one – repeat, no-one – has a crystal ball so it is best to prepare for all eventualities, with a mix of equities and bonds, possibly property, although the right balance will depend on your own personal investment goals, target returns, time horizon and appetite for risk.

If anyone is unsure as to how to go about this, the good news is there are fund managers who can do this for you (albeit in exchange for a fee):

  • On the fund side, you can buy multi-asset or multi-manager funds (the Schroders MM Diversity range is just one example here), which will provide you with a broad spread of geographic and asset exposures.
  • Investment trusts also cater for this area. There are a number of investment trusts which invest in other investment trusts, again to provide welcome diversification, and protect the downside while seeking upside. The F&C Managed Portfolio Growth and F&C Managed Portfolio Income trust, run by Peter Hewitt, are just two examples, though there are plenty of others.
  • Investment trusts now also offer a new, Flexible Investment category, as defined by the Association of Investment Companies. There are nine trusts to be found in this area, each with a different style and mandate and with holdings which range from global stocks to bonds, real estate and even hedge funds. They may not appeal to everyone but at least their ongoing charge figure of 1.08% a year is no higher than the average for the AIC’s members.

Whether any of these potential strategies are appropriate will again depend on a client’s personal circumstances and preferences but all can be researched easily online through our own website and other free information providers.

Focus on causes, not symptoms

For the moment, markets seem to be pausing for breath and the FTSE All-Share is still only skirting the fringes of bear market territory. If it did cross the 20%-down threshold, it would be the eleventh such downturn since 1962 and as such would hardly be unprecedented.

A lot of hot air has been expended and forests have been chopped down to point the finger at oil and China as the causes of the current malaise, but in this column’s view they are symptoms of the problem, not its roots.

Other symptoms include a broader fall in commodity prices, a horrible spike in junk bond yields and borrowing costs for heavily-indebted corporations and a plunge in emerging market currencies, bonds and stocks.

In this column’s humble opinion, the potential causes for this market mayhem include:

  • A long, six-year bull run which has left stock markets looking expensive on some metrics, notably market capitalisation-to-GDP.
  • A growing list of corporate earnings and dividend payment disappointments, across a host of industries, and not just oil or mining.
  • Gathering fears the US Federal Reserve has tightened monetary policy just when the global economy is losing momentum.

Behind all of these lies the issue of debt. Since the 2007 great financial crisis, global indebtedness has soared by at least $57 trillion to reach $199 trillion (according to a report from the McKinsey Global Institute) and those liabilities continue to weigh on growth, even though record-low interest rates mean the running costs on these borrowings are modest. Heaven help us if interest rates ever go up.

Global debt levels have risen by at least 27% since the financial crisis

Source: McKinsey Global Institute

These issues mean the market has – for the moment – begun to fret about a fresh recession and even deflation, rather than hope for (and price in to valuations) a faster recovery and inflation. This change in mindset explains the poor performance of risk assets like equities and commodities, as well why sovereign bonds, gold and the dollar have been doing relatively well, as investors dash for safety.

Ups and downs

Such an asset performance pattern shows that markets are currently fearful rather than greedy. As noted in prior weeklies we can use transportation indices, small cap indices, market volatility measures and other pointers to measure the market’s mood.

Even if they start to turn upward and confidence returns, care will be needed. Bear markets can be cruel, because they tend to gather pace. The table below shows that across the UK’s 10 bear trends since 1962, the final one-third of a bear market sees two-thirds of the total decline, as clients lose heart, become frightened and then finally capitulate and throw in the towel.

Final third of a bear market typically provides two-thirds of the decline

Source: Thomson Reuters Datastream

Bear markets can be wicked in another way too. Our analysis of the last two, really big bears – 2000 to 2003 and 2007 to 2009 – shows that there were several big rallies during each one. Unfortunately, they simply lured the unwary into a bear trap, snapping shut behind them and inflicting more losses.

Between 2000 and 2003, there were six rallies. They lasted an average of 65 days and the markets rose by an average of 15%, even as the market plunged by 51% from top to bottom.

Six rallies trapped the unwary during the 2000-03 bear

Source: Thomson Reuters Datastream

A similar fate awaited buyers-on-the-dips in 2007 to 2009. Seven rallies lasted for an average of 41 days as they generated an average 14% gain, yet the market still fell by 49% overall.

Six rallies trapped the unwary during the 2000-03 bear

Source: Thomson Reuters Datastream

Note how on every occasion bar one, each bear market rally ended on a lower new high and then retreated to a lower, new low. If this pattern is repeated this time, we nearly need to see the FTSE All-Share sustainably rise above its last two highs of 3,480 and 3,526 if it is to ward off the bear and make a fresh assault on last year’s all-time summit of 3,834.

A sustained move above 3,500 in the FTSE All-Share could be a good sign

Source: Thomson Reuters Datastream

New narrative needed

Usually, the market only finds a bottom when no-one wants to buy the dips and hope is extinguished. That is when true bargains can be found and valuation will be the most reliable long-term indicator in this respect, even if no buzzer will sound and cheap assets can get cheaper still during a panic, so valuation is less use as a short-term timing tool.

One indicator suggests the market is already potentially looking cheap.

The big premium offered by the FTSE 100’s dividend yield relative to the 10-year gilt yield suggests stocks are already cheap. This is the third time since 2008 the premium has passed 200 basis points (2%) and on the prior two occasions the market rallied.

UK stocks look cheap on a dividend yield basis …

Source: Thomson Reuters Datastream

Another indicator looks a little less encouraging.

Even after the latest fall, the FTSE All-Share’s market-cap-to-GDP ratio is around 100%. This sits broadly in the middle of the post-1995 range, to suggest British stocks are nearer fair value, while this indicator has gone as low as 70% during times of market strife.

… but the market cap-to-GDP ratio offers less comfort

Source: Thomson Reuters Datastream

In the end, someone somewhere will decide enough is enough and that stocks are too cheap – looking at metrics such as earnings, dividend yield and cash flows, as well as market cap to GDP. The honest truth is that no-one knows when this will happen (or even whether it has happened already) so the best way to protect clients is to check their portfolios, make sure they are within their tolerance for risk (as defined by your ability to withstand further market falls) and ensure they are not overly exposed to one asset class, country or industry, without incurring those dealing expenses which in the long run erode target returns.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.