Clipping the Worst Parts of a Bear Market

Clipping the worst parts of a bear market will cut risk and boost returns.

What do Warren Buffett, Jack Bogle, and 80% of the investment industry have in common? They all preach the gospel of Buy & Hold investing. They tell investors to stay fully invested in stocks and other so-called “risk” assets, regardless of what is happening in the capital markets, the economy, or the geopolitical realm.

I think this is a biased, self-serving and patronizing message.

Biased because there is an assumption that the only alternatives to buy & hold are market timing and frequent trading.

Self-serving because the compensation structure of the investment industry favors buy & hold over other strategies.

Patronizing because it assumes investors are incompetent, emotional, and dumb.

Most investors are not stupid

The investors I’ve worked with over the years are not stupid. They are acutely aware of the fact that bear markets are a regular and normal part of the investing landscape. Naturally, they become concerned and emotional when bear markets are in full swing. But when they call their advisor, what they hear most often is, “don’t worry – the market always recovers from these downturns. Just be patient and it will all blow over in time.” But is that really good advice? Is it helpful for a client who is anxious to hear that she shouldn’t be anxious? I find it more than a little patronizing.

Take Goldman Sachs, for example. Say what you want about the “Vampire Squid” (Matt Taibbi’s pet name for them), they are still the premier firm on Wall Street. They attract the smartest people from the best schools, and they have unparalleled resources at their disposal. And they do not preach buy & hold.

Goldman Sachs says ‘buy and hold’ investing is broken. Goldman’s Hugo Scott-Gall wrote in a research note to clients that “Returns aren’t as strong as they once were from simple buy-and-hold strategies.” And I agree with them.

Recessions: the bane of every investor

The most destructive force for the stock market is the economic recession. They happen about every 6.3 years or so. They cause high unemployment, bankruptcies, and significant losses for investors. Advocates of buy & hold investing say you should ignore recessions, and stay fully invested throughout. They claim, correctly, that eventually the recessions end and the market returns to pre-recession levels. But here’s the question: Is it really necessary to sit still and endure a decline of 20, 40, or 60% of your account value? I don’t think so.

Recessions are very difficult to predict. But it is quite possible to recognize the signs that a recession is coming sometime in the next 6-9 months. I know this because I have a model that has been doing that since 1957. With an 88% accuracy score, it’s possible to avoid the worst part of a bear market that accompanies an economic recession.

Slide Show

What follows next is a presentation of how the knowledge of an approaching recession can cut losses and boost returns.

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How to use Clipping as a risk-reduction overlay to existing investment strategy

 

Practical application 

I began developing my recession forecasting model in 1983. It took me until 2003 to arrive at the current configuration. I tested it back to 1957, and I have been using it with clients since 2004. It does not detect bear markets that are not linked to recessions, but it is very good at giving early warning when a recession is imminent.

I offer this model as a risk-management overlay to existing investment strategies. Keep doing what you have been doing, while my model operates quietly in the background. Every 6.3 years or so, the model will be called up for service. When that happens, you activate your defensive plan.

For some clients, that means reducing exposure to risk assets gradually and systematically over several months. For others it means getting out of risk assets right away. How you use the recession signal is up to you, and it all depends on what your risk preferences are.

If you want details about this model, message me through my website.

About the Author

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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