Warnings Signs of a Bear Market? Mirror Images Between 2000 and 2007

By: Tom Madell | Wed, Jan 2, 2008
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It was the 1st quarter of 2000. We were still, for all anyone knew, happily enjoying ourselves within a long-standing bull market. Of course, not even worried prognosticators knew it (with any degree of certainty) at the time but a bear market was about to start. By the end of that year, some types of stock funds, although not all, were indeed showing a definite falling off from the near steady rise that had begun five years earlier.

Here is how the average fund would perform but only as revealed at the close of that year:

Total Return For the Entire Year 2000

Large Growth -16.3%
Large Blend - 9.0
Large Value + 1.3

Mid-Cap Grth -10.0
Mid-Cap Blnd + 7.1
Mid-Cap Valu +16.7

Small Growth - 5.0
Small Blend + 5.1
Small Value +17.8

S&P 500 Idx - 9.1

As you can see, most of the major fund categories performed subpar (up less than 10%) or worse, except for small/mid value stocks. Large cap stocks performed particularly poorly.

Compare this to data for the prior bull year ending 1999. In this case, every single category was positive, several hugely so, with the return on the benchmark S&P 500 Index a healthy 20.2%.

Now look at the same data for just finished 2007:

Large Growth +13.5
Large Blend + 6.2
Large Value + 1.4

Mid-Cap Grth +15.0
Mid-Cap Blnd + 4.8
Mid-Cap Valu + 0.8

Small Growth + 7.6
Small Blend - 1.1
Small Value - 6.0

S&P 500 Idx + 5.5

While most of the categories remain positive, all of the returns have been subpar except for two growth categories. Small stocks have been mainly laggards. And, as in the last full year before the 2000 bear market, the bull year preceding 2007 was much more favorable, with most categories near or above 10% and the S&P 500 up a respectable 15.8%.

What does this tell us? Certainly there appear to be some similarities between the pattern of category performance in the year the bear market suddenly took over from the bull in 2000 and 2007's performance. Volatility increased sharply in 2000 just as beginning in mid-2007. Returns drifted lower for the majority of domestic categories while one formerly out-of-favor style, namely most value funds in 2000 and growth funds in 2007, reversed course and ended doing just fine. So, indeed, one might even think of 2000 vs 2007 as near mirror images, with an almost complete reversal in the performances of growth vs value, and large vs small. (For those few of you who may be familiar with my research work in depth, you may recognize that these are the very kinds of reversals I have been writing about since the 1999 inception of my not-for-profit website, http://funds-newsletter.com)

Here's another important similarity: During both 2007 and 2000, the S&P 500 Index, while doing well in the first half of the year, showed flat or declining performance during the 2nd half.

While no one can say for sure what this data portends, we think it reasonably likely that the falling off in consistently positive performance in 2007 from 2006 may indicate that the best days of the 2003-2007 bull market are now history. These reversals may also support our frequent contention that after 5 or more years of huge outperformance, investors often start turning away from categories that have performed best toward categories that currently appear to show greater upside potential.

We think that this reversal of fortunes, if sustained, could carry over to international stocks as well. Such funds, regardless of whether emerging markets or more mainstream developed markets, have been one of the best performing places to be over the last 5 years, just the way all growth categories had been at the start of 2000. International stock funds faired significantly below par in 2000, dropping a substantial 15.6%. Most still appear to be in a strong bull market as of the end of 2007, aided further in performance terms for U.S. investors by the falling dollar. However, they seem to have decelerated from their breakneck, but likely unsustainable, pace as witnessed by significantly more modest gains in the latter part of 2007 than earlier in the bull market.

WHY ARE WE REMINDING YOU SO MUCH OF THE 2000-2002 BEAR MARKET? (Perhaps many would like to get past such unpleasant memories!) Mainly, we hope that investors can refocus on just how bad it can get if we indeed do enter into a new bear market (or already stealthfully have, since we may continue to pull back from 2007's highs.) Granted, the last bear market was the worst in a generation or more. But even if the losses of a potential bear market turn out only HALF of what they were during 2000-2002, it makes sense for all of us to consider taking some precautions.

We believe it is far better to reduce your allocations to the riskiest areas of the market at the start of a bear market, or even before, than it is to sell in the middle of a bear market, or worse yet, when the bear market has been going on for quite a while and is possibly nearing an end.

Here are the 3 year annualized results that were seen by the time the last bear market was over at the end of 2002; the 1 year results for 2000 have already been shown above:

Annualized 3 Year Return (Average Return for EACH Year) For the Period 2000 Through 2002

Large Growth -11.1% (E.g. Buy and hold losses would be 33.3% of your entire investment!)
Large Blend - 6.6
Large Value - 1.1

Mid-Cap Grth - 8.9
Mid-Cap Blnd + 2.7
Mid-Cap Valu + 9.3

Small Growth - 3.5
Small Blend + 8.2
Small Value +14.7

S&P 500 Idx - 4.1

Internationl Stocks - 4.0

Extrapolating to the present, if you could currently identify before too much damage is done which categories are fraught with the most danger, and which would be relatively safer, you would be able to take action which could help you minimize potential portfolio losses. Back in 2000, small-caps and value funds were your best protection if you wanted to stay invested in the stock market because they had been out of favor for many years prior. The same appears to be true today for large-caps and growth funds.

Be clear though: We are not "predicting" a bear market. That is, we can't say any better than any other purported "expert" that stocks WILL drop 20% from their recent highs, or, EVEN IF THEY DO, whether that drop will be long and deep enough to give one subpar returns over the subsequent 1, 3, or 5 year periods. But what we are saying is that investors should always be mindful of such a possibility, especially now. We are presenting data here that no one else we know of besides us has done research on and published, that seem to give a convincing argument that a bear market ahead seems to be a real possibility. We can't, and won't, try to give you the odds of it happening because that would be mere guesswork.

Now that we have given you some real data with regard to the issue, we leave it up to you to decide what to do next. It seems to us that the more you believe that such potential bear declines (which are almost always time limited) will wind up hurting you, the more you will want to take some protective action, and do it sooner rather than later. For example, if you feel you must absolutely maintain a certain amount as your investment "nest egg," you will be highly likely to come to the decision get out of the stock market once a bear market starts and you see that nest egg potentially falling below that defined level. Likewise, if you determine, either now or during a bear market, that a certain percentage loss will be too great a risk for you to continue to hold your funds, and that percent gets near or is even exceeded, you will also likely exit. If these examples seem to apply to you, then it may behoove your to make some gradual adjustments to your portfolio now to prevent having to take wholesale action, with potentially greater losses, later.

In general, then, if you don't think you will be able to comfortably accept the possibility of losses such as those above over a one or more year period, then perhaps it would be wise to begin making some adjustments to your portfolio. My Model Portfolios, available free from my website, are based on your self-defined willingness and ability to accept the very real risks when investing, do try to factor in these risks. These risks are present even for people who consider themselves long-term investors, although the risks lessen somewhat the longer you are able to keep your investments in stocks.

We don't recommend getting out of stocks to too great an extent on the basis of a potential upcoming a bear market since stocks held long term will almost always outperform all other types of investments. In fact, bear markets can actually represent great buying opportunities. But it is best to try to avoid some of the worst potential pitfalls, while at the same time maximizing your chances of doing well, by focusing on the relatively safest appearing categories. Obviously, there are no guarantees! And, of course, if one acts before a bear market is even known to be coming for sure, you risk getting out of what could still continue to be some excellent investments. So there are elements of risk no matter what you do! Fortunately, our research has been quite successful at helping people deal with these very questions: how to profitably manage risk in the financial markets, notorious for their seemingly unpredictable ups and downs.

Incidentally, you might be curious how most bond funds did over the same periods mentioned above. During 2000, when the last bear market began, the typical high quality taxable bond fund returned in excess of 10% (vs. less than 0% during 1999). Over the entire 3 year stock bear market, taxable bond funds averaged a yearly return of 7.7%, which was not bad vs. the negative yearly returns of the average stock fund. What about for 2007? Once again bond funds have shown respectable returns. Through year end, many of the best high quality bond funds have returned even more than the S&P 500 Index - from close to 6 to as much as 10% or higher. In 2006, the average bond fund returned only about 4.3%.



Tom Madell

Author: Tom Madell

Tom Madell, Ph.D.
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