What to do during an emerging bear market

When I wrote a guide to investing for a recession back near the start of May, there was no way of knowing that just six weeks later it would be quite so apt.

In the intervening weeks, the chances of a recession have literally skyrocketed in the US and the rest of the world for that matter.

Many world markets have plunged into a rapid correction (a fall of 10%) then bear market (a fall of 20% or more), and Australia is now well on the way.

So, while there is no need to change a word of how to invest for a recession, the strategy could now do with some refining for dealing with the first stage: investing during a bear market.

Adjust to falling share prices quickly

Well, the first and most obvious thing about a bear market and a possible recession is that shares are falling rather than rising.

That requires a different mindset – particularly as the average recession driven fall in the US share market is 32%.

By that measure, believe it or not, the Nasdaq is already there, and the S&P 500 only has 8% to go which is a measure of how quickly things can change.

Of course, averages only get you so far and the scary thing about markets is that they are inherently unpredictable and can overshoot in both directions.

The only person who claims they know exactly where markets are going is sure to be a fraud.

It would be unwise in the extreme to put too much weight on past averages given that we are in the early days of this bear market and things are changing very quickly.

A bear market is a healthy change

What we do know about bear markets is that they are an essential part of the way the share market and the business economy works.

Companies that may have grown quickly on potential future earnings during a bull market – such as many technology stocks – sometimes wilt and even collapse during the rigours of a bear market when the easy money has stopped flowing.

This leads to two very rational responses to a bear market – to fine tune your investment strategy to select only quality investments that have solid, steady cash flows and pay dividends and to look for companies that are good value.

You should always aim to buy companies that have quality earnings and profits, but this becomes even more important now.

Try to buy on the cheap

There is a very good reason that great investors like Warren Buffett get excited when a bear market arrives.

After often years of looking for reasonably priced companies, someone like Buffett is all of a sudden busily working through a lot of opportunities, looking for the best ones.

You can make a lot of money in a bull market just following the crowd and jumping on to the next big thing, but in a bear market you can make the ultimate investment – one that will truly set you up for decades.

The key is valuation, and a bear market compresses valuations of companies good and bad, meaning you can buy a strong company with a solid and growing business much cheaper.

Almost always when you hear of “holy grail” investments that pay back their purchase price every year in annual dividends, it was a bear market that created the original, exciting buying opportunity.

Time in the market – investing like a super fund

If you treat your share market portfolio as a long-term asset, the last thing you want to be doing is chopping and changing all the time.

The one exception to that rule is to perhaps rid yourself of any highly speculative stocks that don’t seem to have much of a future and are a hangover from the now defunct, long bull market.

There are too many opportunities to buy shares that are excellent value without having your attention distracted by what have probably become fringe investments.

The best way to think about building your portfolio during a bear market is to act like a super fund, which is designed for long term performance.

You don’t see super funds selling out of shares and turning all cash at the first big fall in the market.

Instead, super funds use time in the market rather than trying to time the market to get great results.

Dollar cost averaging can work

Super funds use a gradual purchase or dollar cost averaging strategy which magnifies gains and minimises losses because in a weak market the fund buys more shares.

Then when the market recovers – whenever that might be – that greater number of shares bought when markets were down turns into a fantastic investment.

If you look back over years in which your super fund has probably outperformed, it will often be just after a bear market when those purchases at cheap prices finally reflect their true value.

The most recent example would be after the March 2020 COVID-19 crash, which was nasty and sudden but followed by a quick recovery.

This time the recovery might take much longer – nobody knows for sure – but by staying in the market for the long term and sticking with quality investments, the tide will likely turn.