Sunday, April 12, 2009

Bear Market Rally ?

It's worth reading..

Is this the real thing, or just another Bear Market rally? So far, we’ve had 4 runs of about 20% each.
Here are 3 things to keep in mind:

1) Follow the Playbook: The smart investor’s playbook is very different in bear markets than bull markets. In a Bull Market, you buy the dips. Lower prices are an opportunity to buy into equities at cheaper valuations. Most sales are disappointing, as prices eventually go higher. Buy & hold is the simplest, most cost effective investment strategy.

Bear markets call for a very different set of plays: You sell the rallies; higher prices are opportunities to sell equities at premium valuations. Most buys are disappointing, as prices eventually go lower. Buy & hold is a losing strategy – trading what the market presents to you is the best risk management strategy.

The goal during bull markets is to grow your capital; the goal during bear markets is to protect your capital.

2) Beware the ‘Conspiracy of Optimists’: In the run up to the top of the bull market (October 2007), there is an overly positive view of the world, a misconception amongst the broader populace as to what is actually happening. Warning signs are ignored as foolish memes are promulgated.

Recall these absurd rationales:

• Damage from Subprime mortgages was “contained”
• The US economic slowdown would “decouple” from the rest of the world;
• The conundrum of ultralow interest rates were the result of a “excess savings”

All three of these proved false. And, to the astute investor, these all contained warnings of the coming investment storm. We are currently hearing similar foolishness from the same perennial cheerleaders. (See the “Green Shoots” from a recent NYT debate).

Four recent economic data points (ISM data, New Home Sales, Existing Home Sales, and Non Farm Payroll) were all spun by Wall Street as if they were positive; if you dug beneath the headlines to review the actual data, they were all terrible.

Understand the difference between an economy that is improving versus one that “getting worse more slowly.” We are experiencing the latter.

3) Buying the very bottom isn’t your goal: This often surprises people – they think they should try to buy at the bottom and sell at the top. The problem with this approach is that we don’t know for sure when it’s the bottom or top until after the fact. And even if you nail the low, you may not make any money.

Here’s an example: In 1966, the Dow first kissed 1,000. It did not get over 1000 on a permanent basis until 16 years later in 1982.

But if you managed to catch the exact low in December 1974, well, then, you better have had a strong stomach – the volatility was brutal. That low was followed by a 75% rally, a 27% sell off, a 38% rally and a 24% sell off. But those are nominal numbers. Adjust the returns for inflation, and you actually lost about 75% of your money in real terms. (No thanks!)

Instead, consider as your goal maximizing your returns on a risk adjusted basis. This means being more conservative with your investments when risk levels are higher, and more aggressive when they are lower. For many investors, dollar cost averaging into broad index funds works well. It is efficient and cost effective. If you want to be a bit aggressive, you can increase your contributions once the markets fall 30% or (like now) 50%. The time to throttle back a bit? After a 4 -7 year bull market run.

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