How to Invest for a Bear Market

Smart Investor's Guide to Preparing for a Down Market

Bull and Bear Market
••• Getty Images/Jonathan Evans

What is the best way to invest during and prior to a bear market? There are certain types of stocks, bonds, and mutual funds that perform better when the market is in decline. You shouldn't wait for the announcements that the market is bearish; the best time to begin preparing for a market reversal is before it begins.

What Is Bear Market?

A market correction is a market occurrence where, as a whole, prices drop between 10% and 19%. A bear market is a market condition where prices have fallen more than that of a market correction, 20% or more. It is common investor knowledge that there have been 22 market corrections, but only four bear markets have occurred since 1974.

The length of time that the period of generally declining prices lasts is called the "duration." Historically bear market durations have ranged from approximately three months up to more than three years. Of the officially recognized bear markets, the durations were longer than one year but less than two years.

Is There a Bear on the Horizon?

There is no magical bell that rings when a bear market begins. In the past, bear markets have always been preceded by a market correction. However, the problem lies in that not all corrections have led to bear markets. Since some corrections have led to bear markets, investors become nervous when the market corrects itself—they fear the bear and the losses that are brought by it.

This generally results in investors trying to time the market—which is not a recommended investing strategy. Bear markets tend to present themselves when market prices have been rising for a time, and investors are feeling irrationally exuberant—a feeling described that can be described as a gambler's high during speculative bubbles, where speculators drive prices higher and higher.

Types of Investments for Bear Markets

One method of investing during a bear market is to purchase stocks at reduced prices. You should be cautious with this approach, however; stocks you buy in this market condition should be from corporations and entities that have weathered economic downturns before.

For this reason, many seasoned investors advise purchasing toothpaste stocks—these are not necessarily stocks from companies that make only toothpaste, but stocks in companies that produce a large number of items people will always need such as toothpaste or other living necessities.

Johnson & Johnson and Colgate-Palmolive are two examples of companies that are considered toothpaste stocks.

If you have chosen your investment tools wisely, such as a 401(k) or index funds, you should continue contributing. The initial descent might bring the overall value of your 401(k) or fund down, but the purchases on the way down will be at a discount. When the market turns around again, you will come out on the other side with more value as prices rise in the bull market.

Bonds and precious metals typically are investors' allies when a bear market emerges. These assets have generally performed well in past bear markets, where stock prices and interest rates are going down.

Bear Markets and the Federal Reserve

No one is yet able to predict exactly when a bear market will begin. But one clue that might help identify a bear market closing in is when the Federal Reserve (the Fed) begins to raise interest rates again after a period of lowering them.

When the Fed starts to raise rates, it generally means the economy is healthy and maturing, which typically occurs toward the end of a growth cycle (towards the end of a bull market, and closer to the bear market).

Bear markets and recessions do not always occur hand in hand, but it can happen.

What this means is that investors would do well to stay fully invested (up to their respective risk tolerance) when the Fed is actively decreasing interest rates or keeping them low. Corporations will borrow money at low rates, which often translates into more profit as they invest the borrowed money in technology, or simply to refinance debt from higher rates to lower rates. This generally occurs towards the peak of a bull market.

A bull market typically peaks before the economy peaks. This is because the stock market is a forward-looking mechanism, a "discounting mechanism" and a "leading economic indicator." In other words, the stock market will begin its bear market decline before it is officially announced that the economy is in recession. In simple terms, stock prices today reflect investors' best guess as to near-future conditions, whereas economists and the Fed look back at the recent past to guess current economic health.

Stock market peaks and economic peaks occur at different times. This is because stocks are generally being traded before companies are gathering revenues.

The S&P 500 P/E Ratio as an Indicator

An index is a benchmark for certain assets. The Standard & Poor's (S&P) 500 Index is a performance benchmark for the top 500 stocks (in the view of S&P) on the market. The price to earnings ratio (P/E) can be used as a gauge of valuation of the stocks listed on the index at any given time.

While this is not a consistently accurate means of predicting short-term stock market fluctuations, it can be used as a general barometer for determining if stocks may be over or undervalued.

If you learn how to interpret the overall value of stocks by using the P/E ratio on the S&P 500, you can gain insights into investor sentiment towards stocks, and therefore, a possible future direction of equity prices—because when assets become overvalued, investors begin to panic sell to mitigate losses. This can cause a market correction, or lead to a bear market—however, it might not cause anything but a small dip in prices.

Caution must be taken when trying to predict and base investing decisions on what the market will do. Many investors have lost everything trying to time the market.

The P/E ratio of the S&P 500 Index is not a simple ratio to obtain. One method is to look at each stock listed on the index and find the ratio on its page or calculate it. An internet search might provide someone else's results from calculating the P/E.

If you find your stocks have P/E ratios less than those you analyze from the S&P 500, you may want to reduce risk in your portfolio by decreasing your exposure to stocks (the number of stocks you hold).

Tactical Asset Allocation

Asset allocation is the greatest influencing factor in total portfolio performance, especially over long periods of time. Therefore, an investor can be just average at investment selection but good at tactical asset allocation and have greater performance, compared to the technical and fundamental investors who may be good at investment selection but have poor timing with asset allocation.

Consider this example of tactical asset allocation: Assume you see some classic signs of a maturing bull market, such as high P/E ratios and rising interest rates, and a new bear market appears to be on the horizon. You can then begin to reduce exposure to riskier stock funds and your overall stock allocation and begin building your bond fund and money market fund positions.

Having a portion of your portfolio you can switch back and forth for different market circumstances can help you continue to make gains.

Let's also assume your target (or "normal") allocation is 65% stock funds, 30% bond funds, and 5% cash/money market funds. Once you see P/E ratios at high levels, new records on major market indexes, and rising interest rates, you might take steps to reduce risk by reallocating to 50% stocks, 30% bonds, and 20% cash. All that remains is the actual mutual fund types that can help in reducing your overall portfolio's market risk.

Now consider that the average duration (length) of a bear market for stocks is one year. By the time economists herald the news that a recession has begun, the bear market may have already been in its downward spiral for three or four months, and if the bear market decline is below average in duration, the worst may have already passed by that time.

Prepare For Different Markets

You may want to begin preparing your portfolio for bear and bull markets before they begin, rather than waiting until you know for certain a bear market has begun. You should work to build a strategy and portfolio structure before you begin to buy funds.

Create a diverse portfolio, tactically allocate your assets, be prepared to move small portions of capital around, and keep an eye on the market indicators. These methods can help you keep your portfolio earning when market reversals occur and can keep you from succumbing to the panic that other investors and speculators will feel when the bear stands up.