My current bullish market outlook notwithstanding, I want to look ahead to the inevitable next bear market. To give some context, I have written about a “post-August moonshot” and a “12-18 months” maniacal phase leading to a target of 10,000 on the NDX and about 3500 on the S&P. Together these projections should provide enough contour of an anticipated top. I like to think ahead so as not to get caught unprepared when changes occur. Being early also gives me a claim to some originality of thought then the time does come.
Readers should know I’m a habitual violator of the cardinal rule of making predictions on the stock market: target price or time but not both. It’s a luxury reserved for a no-name blogger with zero reputation to lose. On the other hand, I have my own money on the line and disclose the transactions and results every week and every month. When real money is involved, doubt, conviction, hope and regret have nowhere to hide. It is not sufficient to make correct projections, there also has to be enough conviction to capitalize on them. In the end, the only arbiter is the balance in the account.
In terms of the big picture, the view that most resonates with me is that of of Chris Ciovacco. He has a YouTube channel and here is a clear enunciation of his views: we have broken out of a 17 year consolidation box and is embarking on a decade plus journey higher.
Another key understanding relates to the length of the current bull market which many put at over 8 years counting from the Mar’09 low. Putting aside the argument that a bull market does not start until the previous high is exceeded, cases can be made for both May-Oct’11 and Aug’15-Jan’16 being bear markets (source), which resets the clock on the current bull to less than 2 years.
The Next Bear Market
The model I follow does not have a good record of predicting bear market bottoms which tend to overshoot the model prediction (I don’t plan on giving details of this model on this blog). My current interpretation is for a regular bear of a decline of 20-30% in the S&P for a duration of 12-18 months. In (very) rough round numbers, that’s from 3500 back down to 2500 on the S&P. The important take-away is that I don’t expect it to be the comeuppance that many doom-and-gloomers are calling for. The 50+% decline of the GFC has scarred a generation which paradoxically means it won’t happen again until the memory fades.
Execution is what separates a practitioner from a prognosticator. With a 30% decline that may take 1-2 years to recover, both holding tight and some defensive maneuvering are viable strategies. In a blog post as far back as May’17, I discussed my defensive asset allocation for the passive accounts: 40% equities, 45% fixed income and 15% PMs. Within equities I removed REITs, small tilt and EM. The FI allocation is modified to include bonds, treasury in particular instead of stable value exclusively. Most of the passive accounts are in 401K or Roth so there is no tax consequence for making these adjustments. The exact allocation will depend on the availability of funds in each account but there has been no change in the overall direction.
In the active accounts, the consideration is more complex. It’s reasonable to expect a deeper drawdown in tech which is the vessel of the current bubble. That said, given the taxes (includes CA taxes for me) and uncertainty in timing, selling then re-buy in taxable accounts is not a slam-dunk proposition. It’s much more advisable to hedge especially if one believes the overall technology trends are still intact and the bear market is just a reset of expectations. There are several workable option strategies for both individual stocks and indexes that are similar to the inverse of what I’m using for the current bull market.
At this moment, I expect both treasuries and PMs to be bid during the next bear market. Treasuries may be something to “re-balance into” when the 10-year yield gets above 3%, while PMs will likely be the next bubble where gold gets up to $3500-5000/oz. In short, there will be plenty of sources of return to keep the portfolio growing during this phase.
Impact of the Passive Investors
In Some of You Will Sell or the Achilles Heel of the Arithmetic of Active Management I discussed two type of passive indexers: type A who buys no matter what and holds through the bottoms and type B who sells at the wrong time. Since emotions have been shown to conspire against investors the assumption is that on net passive indexers will achieve less than market returns due to poor timing of type B indexers. From the large number of type B indexers we can expect a sharp decline. Conversely, type A indexers will temper the depth of the market bottom and set the tone for a gradual recovery. This understanding should inform the profile of the hedges to be put on. Moreover, the P/E at the next market bottom should be elevated vs. historical averages which will prevent many from recognizing it until much later.
I remain convinced that active to passive is a secular shift that won’t abate in the next bear market. It’s not obvious that the average active mutual fund can out-perform in a bear market. The trend will continue until easy-to-exploit inefficiencies appear. Will it be some float based mechanism? Who knows. The deeper question is what happens to market returns in the mean time.
The Other Side of The Next Bear Market
In Diversification, Adaptation, and Stock Market Valuation, Jesse Livermore (pseudonym) at PhilosophicalEconomics poses a fundamental question about the equity risk premium. If buy-and-hold stocks is such an EASY way to achieve superior returns (remember the next bear market will be shallower and briefer than most doom-and-gloomer will have you believe), then why should it offer superior returns in the first place? If the equity risk premium should decrease or disappear, we should expect the baseline P/E level to increase and future returns to be commensurately diminished.
My current projection of the 10-year equity return is under 4.5% nominal. Coupled with 10-year bond yield under 2.5%, things do not look good for current and recent retirees. Based on these numbers, I predict that the 4% rule will fail for the Jan 2000 cohort, see the 2000-2016 case study at EarlyRetiremenNow. This is preventing me from fully embracing the optimistic views of Chris Ciovacco. It’s possible that the current QE fueled bubble is pulling forward some future returns, further suppressed by higher future baseline P/Es.
Popularity sows the seed of its own demise in financial markets even for a high-capacity strategy like market cap indexing. If too many people try to make a living from market returns, then there won’t be enough to go around. The democratization of investing may distribute equity returns more fairly but at the expense of making them anemic for everyone. One can argue that economic expansion and productivity gains will save us but I’m not so sanguine given demographics and the move from DB to DC retirement plans. Let’s hope an answer emerges soon. In the mean time, there’s an exciting and hopefully profitable ride ahead of us.