Mark Hulbert: What the next bear market will look like

Are you willing and able to stick with your current equity exposure through the next bear market?

That is one of the most crucial questions retirees should be asking themselves right now. If your answer is no, then you should take the opportunity now—with the stock market close to all-time highs—to reduce your stockholdings. Don’t wait until the bottom of the next bear market to discover that you don’t have what it takes.

There’s no shame in admitting you don’t have the discipline. Claude Erb, a former fixed-income and commodities manager at mutual-fund firm TCW Group, once told me that “the people who can truly stomach the volatility of a 100% stock portfolio are either catatonic or dead.”

If there is any shame, it’s in lying to yourself about your willingness to stick to your guns.

The reason to engage in this otherwise depressing exercise is that selling at or near a bear market low is one of the biggest sins of the investment arena, and is particularly harmful to retirees’ financial standard of living. That’s because selling at or near a low means that you will have suffered all or nearly all of the bear market’s losses but (depending on when you get back in) only a fraction of the gains in the market’s subsequent recovery.

Think back (or, if you don’t recall, go back and investigate) how you reacted in the last two severe bear markets. Was your equity exposure on March 9, 2009 (the last day of the 2007-09 bear market) lower than it was on Oct. 9, 2007 (the day that bear market began)?

Then ask yourself the same question about the bursting of the internet bubble: Was your equity exposure on Oct. 9, 2002 (the end of that bear market) lower than where it was on March 24, 2000 (the day of the broad market’s all-time high)?

If in both cases your equity was not lower, then congratulations. You are among the small minority of investors who truly have the intestinal fortitude and discipline to stick to your guns through a bear market.

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Such behavior is rare, however. To illustrate, consider the several hundred stock market timers monitored by my Hulbert Financial Digest. These are professionals, needless to say, rather than amateurs like the rest of us. It’s their job to identify market tops and bottoms, which is yet another way of saying that they will be more heavily exposed to equities at those bottoms than at tops.

It hasn’t worked out that way even for many of these professionals. Their average equity exposure at the March 2000 market top was 10 percentage points higher than at the October 2002 bottom.

The question to ask yourself: If these professionals, who follow the market on a full-time basis, are unable to stay the course through a bear market, what makes you believe you can do better?

Of course, by investing in conservative stocks or pursuing other low-risk strategies, it’s possible to beat these otherwise dismal odds. But you shouldn’t kid yourself about the losses you’ll still incur in a bear market.

The accompanying chart shows the losses of the median newsletter’s model portfolio in the 1987, 2000-02, and 2007-09 bear markets. For context, consider that the average bear market since 1900 has produced a 31% loss for the Dow Jones Industrial Average DJIA, +0.30% The median newsletter’s losses in those more recent three bear markets have been minus 23%, minus 28%, and minus 43%, respectively.