Benefiting From Bear Markets | ETF Trends

We will begin with the obvious, the markets have been volatile in 2022.  There have been several, short-term, fast fluctuations riddled with emotion. In just the last few weeks, we have seen a broad-based sell off fueled by investor pessimism.  

We all know that investing is a lifetime endeavor. Markets are dynamic and will do whatever is necessary to confuse the masses. A successful long-term investment program will depend on making many good decisions in the short-term. Decisions that will allow the portfolio to adapt to the changing market conditions as they occur. This is particularly true when markets get volatile, and the bear raises its head when least expected. It’s important to always remember that making money, during good times, means nothing if you can’t keep it during the difficult periods. 

For the first time since the financial crisis in 2008, we are now in a true bear market. Bear markets do not necessarily mean that you have no alternative but to endure substantial financial damage. Times have changed and we have many more alternatives for managing bear markets, in both stocks and bonds, than we had before. 

This update will begin with an overview of why 2022 is different from any market environment we have seen since the end of the first quarter in 2009, over 12 years ago. The overview will be followed by explaining the anatomy of a bear market. We will finish with a brief discussion about adaptive portfolio management and how to potentially benefit from the existing high volatility, instead of being punished by it. 

Now that we are through the first 9 months of 2022, most investors should be reminded of how a real bear market feels.  Through the conclusion of September, the S&P 500 is down -24%, the Nasdaq is down -32.5%, and the 20-Year Treasury bond is down -29%. The current market environment cannot be confused with a rare “trading anomaly” like we saw at the beginning of the covid crisis in 2020. 

In 2020, we saw an example of what Canterbury calls, a “mega trading anomaly.” The S&P 500 dropped -32% over just 23 trading days. The market then rallied back to breakeven just 5 months later.

The current bear market appears to be a long-drawn-out affair. This bear is showing no signs of ending anytime soon.  

The Markets this Year

Below, we have provided bullet points to highlight the wild swings seen in the bear market of 2022. So far, the year’s theme has been about market volatility. This was particularly true during the 3rd quarter. 

  • The second quarter ended as the S&P 500 recovered from its June low.  From mid-June through mid-August, the market rallied +17% in just 2 months.  At the time, the market index was still down -10% from the high, that was established in the first week of the year. 
  • The +17% advance was quickly followed by a -17% move in the opposite direction to end the quarter. That is a lot of volatility! 
  • In just the month of September, the S&P 500 fell -9.3% which is the worst September since 2002.  The month had 8 “outlier days” (a trading day beyond +/-1.50%). Put into perspective, according to accepted mathematical statistics, the S&P 500 would be expected to have only 13 total outlier days for an entire year.  
  • There have been 62 “outlier days” in 2022—more than 4.5 years-worth of outliers. 
  • September’s decline was broadly felt.  Even the most “defensive” sectors like Consumer Staples, Energy, and Utilities felt the impact of market volatility. 
  • The issues facing many conservative investors has not only been about the bear market in stocks. The bigger issue is about the corresponding bear market in bonds. During September alone, long-term treasuries were down   -8%, bringing their decline in 2022 to a whopping -29%. Worse yet, the 20-year Treasury bond is down -40% from its all-time high in 2020. 
  • A balanced allocation of 60% stock and 40% bonds would be down about    -22% on the year.  In other words, the traditional “conservative asset allocation” has been anything but conservative. 

Bear Market Anatomy

Bear markets, as we have seen this year, are characterized by having high volatility and outlier days that far exceed what would be predicted by statistical analysis.  Bear markets are counter intuitive and will tend to rally when investors are the most pessimistic.

Financial markets are known as being a leading indicator of changing fundamental data. In other words, it is typical for a market, or security, to advance prior to a good report. This is because some investors will become aware of new information and will react to it quickly. Other investors may be less informed or are generally slower to see changes and are slower to react. There is a popular Wall Street saying: “Buy on the rumor and sell on the news.”

On the other hand, the same is true when investors react to bad news, particularly during bear markets. The difference is that investors are more skittish during bear markets, and they are more likely to overreact to the day-to-day news events. Their emotional actions contribute to increasing volatility. When you think about it, behavioral finance, and human psychology, will logically have an impact on liquid financial markets.   

You can see this, in real time, in 2022.  The market has seen several, emotional swings, both up a down.  Investors have felt a different emotion, during every one of these swings, which coincides with the market’s short-term movement. 

The chart below shows investor sentiment, at each market peak and trough during 2022.  Investors have felt more bearish at the troughs prior to a rebound, and less bearish as the S&P 500 has gone higher and put in a relative peak.  

Source: American Association of Individual Investors Sentiment Survey Data.  Chart created using Optuma Technical Analysis Software

Visually, Bear markets will establish a chart pattern of lower lows and lower highs.  Which can be seen above. Bear markets will also have large short-term fluctuations over shorter time periods. Therefore, bear markets will be more volatile and are more likely to have sharp parabolic declines followed by equally sharp short-term advances.  This has been seen over and over again in 2022. 

At the end of the 3rd quarter, pessimism was at its highest level since 2009. This would give an indication of a rally to soon follow. The extent and timing of the coming advance are unknown variables, but when pessimism is at a high, it puts the market in a position to do the opposite of what most would expect, and that is to see a rally.

There are three primary certainties about bear markets.  

  1. Bear markets are volatile. 
  2. The market movements, in both directions, tend to be bigger than what are seen during bull markets, and they happen fast. The biggest up days and rallies tend to occur during bear markets. In other words, if you want to catch a rally, you should add money to equity following a sharp decline when pessimism is at the highest. This is the case because bear market  rallies happen so fast that if you are not already in, it will be hard to be able to get in quickly enough, before the rally ends. 
  3. All bear markets will eventually be followed by a new bull market. The goal of successful adaptive portfolio management is to manage the bear market by adjusting the holdings in a way to maintain a high benefit of diversification. Own securities with low correlation. Low correlation creates low volatility. A portfolio with low volatility will benefit from the markets’ fluctuations, instead of being punished by it. Remember, volatility is the killer of long-term compounding of returns.

Adaptive Portfolio Management

Canterbury’s primary objective is to manage our portfolio in a manner that will benefit from extended bear markets, like the one that we are currently experiencing in both the stock and bond markets.  We use a process called “adaptive portfolio management.” 

An adaptive portfolio should adjust its diversification in a way to maintain what we call an “efficient portfolio”—or one that has consistent, low volatility through variable market environments.  One way to measure consistent, low volatility is through a concept we discuss often and mentioned earlier in this piece, “outlier days.”  As discussed, an “outlier day” is any trading day that exceeds +/-1.50%.  As mentioned earlier, an outlier day statistically should occur once every twenty trading days, or thirteen times per year.  

So far, in 2022, the market has experienced 62 outlier days (six times the expected amount to this point in the year).  Although the metric is slightly different for bonds, twenty-year treasuries have experienced 46 days beyond +/-1.50%, and one balanced Vanguard 60% stock/40% bond mutual fund has experienced 21 outlier days so far this year. 

Year-to-date, Canterbury’s adaptive portfolio strategy, The Canterbury Portfolio Thermostat has experienced only 8 outlier days, which is what you expect to experience in a normal market environment with limited volatility.

Even with that limited volatility, it takes more than limiting outlier days to benefit from a bear market.  An adaptive portfolio needs to limit declines, but also participate in the sharp bear market rallies that are common, and expected, in today’s market environment.  Too much of a good thing (limiting declines) will not benefit from bear markets unless the portfolio can also participate in the bear market rallies.  Because of this, an adaptive portfolio will increase its exposure to equities during the declines, to best participate in the rallies that soon follow. 

Right now, the Canterbury Portfolio Thermostat has fluctuated significantly less than the overall markets and has had half the volatility of even the most conservative of balanced portfolios.  Now, it is in a position to benefit from any upward market momentum, with new exposure to technology-based indexes, while also holding more defensive sectors like Energy, Utilities, the US Dollar, and inverse positions in Financials and Emerging Markets (which move in the opposite direction of their underlying indexes).

Bottom Line

The month of September was a difficult one for many investors, no matter how they were invested.  The broad selloff was felt across the board in all sectors, whether they be technology-related, Financials, or more defensive sectors like Utilities and Energy.  As a matter of fact, virtually every asset class outside of the US Dollar and inverse securities is in a bear Market State, with high volatility.  

This bear market has made investors expect the unexpected.  It was uncommon to see a trading day beyond +/-1.50% in 2021.  In fact, the S&P 500 only experienced 18 of them.  Now, we have seen 62 outlier days, and the year still has a quarter left to go.  A day beyond +/-1.50% feels like a new normal.  The decline experienced last month to end the third quarter has made many market participants feel like throwing in the towel and staying away from the markets.  This is particularly true for those who consider themselves conservative investors, where bonds have done virtually nothing to offset the risks of a declining stock market. 

Benefitting from a bear market takes an evidence-based, adaptive process. Bear markets are full of the unexpected.  When you think things are bad, then you have another decline. When you find yourself feeling the most pessimistic, the market rallies.  No one can predict the markets; the market already knows what we know and it knows it before we know it.  Having a process, like the Canterbury Portfolio Thermostat allows an investor to take the largest disadvantage of bear markets, which are volatile fluctuations, and potentially turn them into an advantage by limiting portfolio declines and benefitting from market swings with the process we have outlined in this update.

We hope this update has been helpful. Please feel free to call the office if you have any questions or comments.

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