Most investors will agree, in retrospect, that a major bear market has been in progress since year end 1968. Certainly, most stocks are now selling far below their 1967-68 peaks. Although many bear market rallies have already taken place and many more will occur in the future, there is little doubt that the ongoing primary bear market will persist beyond the mid-1970's. The world economy has yet to undergo a sizable and lengthy correction.
But there's no real reason why investors should shy away from bear markets. Of course, it's no longer possible to simply buy any stock and let the bull market drive the price up. Trading on "hot tips" and rumors will also prove expensive. But bear markets may actually offer many extra profit opportunities that would not be available otherwise—to systematic individuals.
CASE STUDY. Let's take a hypothetical situation where two investors are interested in buying stock in a growth company selling at, say, 50. Although the issue, having risen sharply, is richly priced relative to earnings and assets, Investor A decides to buy it immediately because he is impressed with the company's long-term prospects. Investor B, however, holds back, convinced that a primary bear market is unfolding and that high-priced stocks usually suffer in such a drop.
During the course of general market decline, the hypothetical stock drops to 30. Investor B buys it at this point. With the same amount of capital, Investor B, by taking advantage of a bear market, is able to buy two-thirds more shares of this growth situation. If the stock recovers to 40, Investor B will have a 10-point gain, as against a 10-point loss for Investor A; and if the stock eventually rises to 60, Investor B will enjoy a 100 percent appreciation, or five times more than Investor A's 20 percent gain.
However, the chances are that Investor A will not hold the stock through the decline to 30 and subsequent runup to 60. As the bear market progresses, he will become increasingly anxious and more likely than not bail out in panic near 30. If he holds, he's apt to get out as soon as the stock approaches 50 on its way back up.
Perhaps the most important part of successful strategy in bear market investing is to have a sufficient cash reserve with which to buy real bargains created during the course of a general market decline. This is so elementary many readers may wonder why we bother to discuss it seriously. The fact is, however, that after 20-odd years of rising stock prices that persisted through the mid-1960s, many investors still become restless holding a fraction of their investment capital in cash for even a few days, let alone hanging on to sizable reserves for weeks or months. For the venturesome, potential buying power can actually be increased in a bear market by using hedges and shorts.
To take profitable advantage of a primary bear market, it behooves the investor to learn and follow the dozen bear market guidelines set forth herewith:
1. Don't sit tight. Hanging on to "good" stocks "for the long pull" and riding through an interim market decline may have proved reasonably satisfactory during the long bull market when the primary trend of most issues was upward. But in a primary bear market, such a course of inaction will prove most impractical and nerve-wracking. Take, for instance, the leading steels like Bethlehem and U.S. Steel, which, for reasons peculiar to that industry, have endured their own private bear market since long before the general decline set in. These issues have trended downward for about a decade and there is little evidence to suggest that shareholders will improve their lot by hanging in there for another few years.
2. Don't look at past highs. Even investors who have every intention of liquidating overpriced stocks often fail to do so because they are waiting for their holdings to return to the peak levels attained during the height of the speculative spree. In all probability, those high water marks may not be reached again for many years.
3. Don't worry about taxes. One of the more common reasons why many long-term investors don't realize the capital gains they have accrued during the course of a long bull market is their reluctance to pay capital gains taxes. Important though they may be, tax considerations should never come before investment merits. It is often far cheaper to pay a tax of roughly 10 percent to 25 percent on only the capital gains than to run the risk of a much larger loss on total capital. This is particularly true in the case of overpriced issues.
Actually, as soon as a stock advances from purchase price, a potential tax liability accrues. It can be removed either by nailing down the profit and paying the taxes or having the stock retreat to or past the original purchase price, thereby eliminating the paper profit. Obviously, the first alternative is the more pleasant.
Another way of looking at the "frozen-in-by-taxes" situation is to consider the tax liability more or less as an interest-free margin debt. While it is good to use other people's capital, interest free, it is not advisable to resort to margin to buy stocks during a primary bear market.
4. Do capitalize on technical rallies. Even during major bear markets, there will be occasional rallies. Some will last several months; others, only a few hours.
The short ones afford excellent opportunities to move out of weak issues. Once again, this rule seems almost too elementary to be worth the stating. However, many investors who intend to sell during the "next" rally often forget their plans as soon as the market makes a strong advance. In response to the market's interim move, their mood changes from one of panic to euphoria and they miss out on good selling opportunities.
The major cause for such emotional shortcomings usually lies in the fact that such investors don't have strong convictions about their investment (or divestment) programs. To be convinced, the private investor must be informed not only about the stocks involved but also about fundamental conditions in the market, the economy, and the monetary system.
Longer bear market rallies, meanwhile, can generate excellent trading profits for the nimble. To take advantage of these rallies, investors should buy stocks only after the market has plunged precipitously for a few months and stocks are technically sold out.
To check if such a truly oversold condition has been reached, check the sentiment of stock brokers and market commentators. When they are worried but are still looking for an imminent recovery, don't buy. But when they sound downright discouraged and begin to talk seriously about depression, start accumulating stocks that have undergone sharp declines.
5. Don't give up investing. In a primary bear market, it is of course safe to simply withdraw from securities markets altogether. But a systematic program of building capital requires an efficient use of funds, and noninvesting is decidedly inefficient. Money can always be put into something other than overpriced common stocks. To cite but one simple example: hedging with warrants and convertibles can be highly rewarding, yet involve limited risks.
6. Don't buy mutual funds. The great majority of mutual funds are bull market creatures. They are accordingly apt to suffer far sharper declines than the market in general.
7. Do select truly "defensive" stocks. When they expect a market decline, many investors instinctively think of buying utilities, or other so-called "defensive stocks." Following this instinct blindly can prove costly. To the extent that these companies are unlikely to go bankrupt—even if a severe recession occurs—or that their earnings do not fluctuate very widely, they can be considered defensive. But unless a given issue is reasonably priced in relation to existing and probably capital market conditions, it's just as vulnerable to price declines as any other.
Truly defensive stocks in today's market are those issues which offer a high and reasonably safe dividend return. If the current yield is higher than the average interest rate of three to five year government bonds, the stock is usually suitable. Investors are becoming so much more income-minded now that high-yield stocks will sooner or later attract their attention.
8. Don't buy low P/E stocks willy-nilly. Premature bargain-hunting is a very dangerous game. In the all-time worst bear market—the 1929-1932 crash—the most staggering losses were incurred not in the initial slide but during the period thereafter.
One of the most common mistakes made by investors is to rush into stocks simply because current price/earnings ratios are lower than the average multiples of the recent past. P/E ratios are not a good investment yardstick. Since 1961, for example, A.T.&T.'s earnings multiple has declined markedly. But there are few shareholders who have bought the stock during the past decade who don't have a paper loss.
9. Do consider bonds. Investing in bonds has not been a particularly profitable proposition during most of the past quarter of a century, when interest rates were trending upward. But before too long, interest rates are more likely than not to move downward. When that happens, long-term bonds will offer appreciation potential as well as generous income.
It's true that bonds do not "swing" quite as feverishly as common stocks. But the enterprising investor can still come out well ahead in such securities. For example, with interest rates likely to be much lower in the mid-1970s, many bonds will probably appreciate significantly in the next several years. There will, of course, be short periods of reverses, which long-term investors may ignore.
10. Do buy gold stocks. The ongoing bear market will be accompanied by a weakening of the economy. And politicians can be expected to respond by "printing" more and more paper money. This cannot help but increase the price of gold—the only time-honored standard of value. Gold stocks will rise in sympathy, especially since demand for the limited number of these shares will almost certainly broaden all around the world.
11. Do seek out special situations. Even during business recessions, there'll occasionally be certain companies that will keep on growing. And if their stocks are not overpriced, they can reasonably be expected to give investors a run for their money while a primary bear market is under way. But even should they hit temporarily, they are likely to recover vigorously once selling subsides.
Right now, for example, some of the senior bonds of bankrupt railroads operating in the Northeast are highly attractive. The assets behind these securities are worth far more than face value of the bonds and many of the bonds are selling at but a tiny fraction of their face value. The new law authorizing the forming of a government-sponsored railroad system to take over these bankrupt roads promises excellent treatment of these bonds in the final reorganization.
12. Do use selected short sales. Generally speaking, selling short is highly risky. But in a bear market, this technique can be put to good use. Indeed, shorting overpriced stocks can be safer than buying even blue chips.
Thus, a bear market need not spell defeat for the sophisticated investor. By following these 12 guidelines, you stand a good chance of coming out ahead—and even having fun—in the bear market of the 1970's.
Thomas J. Holt is the president of New York-based T.J. Holt & Co. which publishes THE HOLT INVESTMENT ADVISORY and manages investment portfolios for private investors. Mr. Holt holds college degrees in economics and engineering.