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While the past decade has generally exhibited falling unemployment, rising stock prices, and other positive economic indicators, it may have also lulled investors into complacency after an extended period of relatively tranquil capital markets. With that said, we have seen recent declines in the market, such as the sharp slowing of the global economy during the COVID-19 pandemic as well as recent volatility through 2022. This exemplifies the importance of being prepared to handle and invest in a bear market.
The American economy has historically had a recession once or twice a decade, so by some measures, we were due for one.1 Accurately predicting when a recession begins is very difficult, so we are not going to attempt to forecast that.
This article will instead provide an introduction to the economic cycle with an emphasis on recessions to familiarize readers with what we may experience during our next period of economic weakness and bear market investing strategies.
The Economic Cycle
The economic cycle is characterized by four phases—expansion, peak, contraction, and trough, seen in the image below. Expansions exhibit accelerating growth, increased new construction, and employment numbers rising as companies hire to grow their operations. People feel good about their jobs and incomes, so they buy new homes and cars, further fueling the economy.
Economies cannot sustain uninterrupted growth forever, so the expansion culminates in a peak, during which hiring, and growth decelerate. The economy then undergoes a contraction, which sees layoffs and rising unemployment, falling stock prices, and lower industrial production.
Contractions happen for several reasons, including less credit available in the economy (as individuals and businesses become increasingly indebted after years of borrowing and lenders extend fewer loans to the more indebted borrowers) or external shocks, such as the spread of a global pandemic.
Finally, the economy reaches its trough before starting a recovery, which leads into the next expansion.
Economic Characteristics of a Recession
The contraction and trough phases may be characterized as a recession, depending on the severity of the slowdown. While recessions are commonly referred to as two consecutive quarters of negative economic production, the National Bureau of Economic Research defines recessions as a “significant decline in economic activity spread across the economy, lasting more than a few months.”2
At this time, the government may take action to stimulate the economy while companies typically adjust their operations to stay competitive in the new business environment. The government may implement fiscal policy (lowering taxes and increasing spending, such as on infrastructure projects to put people to work, as examples) and monetary policy (such as lowering interest rates throughout the economy so mortgages and auto loans are more affordable) to help economic activity pick up.
Companies often become leaner as they lay off employees, take other cost cutting measures, and invest in operational efficiencies (increasing automation at factories). Since World War II, the American economy has had 11 recessions averaging 13 months.2 This means that by the time it has been announced we are in a recession, it may already be close to half over.
When Does it End?
The good news is that an economy cannot contract forever. Necessary services (including healthcare) must still be provided, and we continue to buy consumer staples (food, basic household products).
Businesses and families will then become more optimistic about the future and increase their spending, which becomes the income for other businesses and families. As confidence continues to improve, larger purchases are undertaken in higher numbers (new home, manufacturing plant) and we find ourselves in the early stage of the next expansion.
Investing in a Bear Market
This article will now address possible adjustments to consider with your investment portfolio during a bear market. Please keep in mind this is purely for educational purposes and is not meant to be taken as investment advice.
Don’t Make the Big Mistake
Sometimes the best action you can take is no action. What is The Big Mistake? It is allowing your emotions or anxiety about your investments to cause you to deviate in the short-term from your long-term investment allocation. During times of heightened market volatility to the downside, The Big Mistake is selling out of your stocks or equity mutual funds (when their prices are lower than in the recent past) and holding the proceeds in cash.
It is very difficult to accurately time the tops and bottoms of market movements and remaining in cash would cause you to miss out on the eventual recovery in equity markets (see paragraphs above).
Should I Keep Investing in a Bear Market?
If you are in a position to continue your ongoing contributions, then it is likely a good move to do so. Dollar cost averaging is the concept of making regular contributions and investment purchases, such as $1,000 per month into an equity mutual fund. As the stock market dips, your contributions buy more shares of these mutual funds now trading at lower prices.
For example, if the mutual fund were trading at $50 per share and fell to $40 per share, then your $1,000 now buys 25 shares of the fund, up from 20 shares before the dip. Accumulating more shares at cheaper prices will further fuel your portfolio’s return during the recovery.
Best Investments During a Bear Market
As mentioned above, when we are in a bear market, we are in a period where stock mutual funds, and stock index funds prices are significantly lower than before the initial decline. Therefore, you can think of these prices being sold at a “discount” as compared to what they were previously valued at. This can provide you with a buying opportunity if you have discretionary funds available.
During a market decline, you may lean towards thinking that bonds are a good investment in a bear market. Bonds are generally less volatile than stocks and can be a more secure investment with regards to loss of principal, making them attractive during these times of stock market uncertainty. However, if we use history as a reference, bonds have much less upside growth potential than stocks over the long-term.
The goal when investing in a bear market will be to position yourself to take part in the upside and growth once the market rebounds and begins the expansion process. In the past, stocks have shown much greater growth during expansionary times than bonds, which makes them an attractive investment when we see a sharp decline in stock prices. This is recently exemplified in 2020 as the market rebounded from the initial COVID-19 dip.
Portfolio Rebalancing
Different asset classes (stocks, bonds, etc.) perform differently depending on the economic climate. A stock market dip could cause your percentage held in stocks to fall below its target allocation (let’s say a target of 90% falls to 85% of your portfolio), while your percentage invested in bonds may rise as high credit quality bonds tend to hold their value during times of economic weakness (let’s say bonds rise from 10% to 15%).
Your portfolio is now overweighted to bonds and underweighted to stocks. Portfolio rebalancing would sell the extra 5% in bonds (reducing down to the target allocation of 10%) and using the sale proceeds to buy stocks (increasing your target back to 90% in stocks).
Tax Loss Harvesting
In taxable non-retirement brokerage accounts, we have the added consideration of tax effects when selling investments. Selling investments for a loss is not a desirable outcome, but can be a useful tactic in brokerage accounts, called tax loss harvesting. Let’s say you bought a large cap US stock mutual fund for $1,000. The stock market takes a dip, and the value of your mutual fund falls to $800. You now have a $200 unrealized capital loss and there is no tax effect yet (it is “unrealized” because there has not yet been a taxable event).
You would then sell out of this mutual fund, which realizes the capital loss, and reinvest the proceeds in a similar, but not identical investment to maintain your desired portfolio allocation. Your $200 realized capital loss is used to offset future capital gains you may incur and will lower your future tax burden. It will be carried forward indefinitely until fully used up.
Bear Market Investment Strategies
From an investing standpoint, bear markets can cause investors anxiety. We hope the points above help you navigate future fluctuations in the market.
If you have any specific questions on your financial plan, we would be happy to connect on an individual basis. Feel free to provide your contact information here and one of our advisors will reach out to set up a free initial financial planning consultation.
Marshall Weintraub is a financial advisor with the independent financial services firm, Finity Group, LLC, and coauthored the book Financial Planning Basics for Doctors with a couple of his Finity Group colleagues.
- National Bureau of Economic Research definition of recession – https://www.nber.org/cycles.html, accessed Jan 29, 2020.
- JP Morgan Asset Management – https://www.jpmorgan.com/securities/insights/recession-obsession, accessed Feb 4, 2020.
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Disclosure:
Investing involves the risk of loss, including total loss of principal. Consult with your investment advisor to develop an appropriate investment strategy for your circumstances. This should not be construed as individual tax advice. Consult with your tax professional for specific tax ramifications for your circumstances.
