Making Money in Bear Markets

Most obviously, in a bear market – or, more generally, any period of acute market weakness – stocks go “on sale”. The enterprising investor with spare cash can capitalize on the weakness to make quality investments at a bargain price. Doing so is an example of another investment adage to “be greedy when others are fearful”.

But what of long-term investors who are already fully-invested? How can a bear market possibly be a money-making opportunity for them?

By not allowing a market decline to frighten a long-term investor into selling, he or she rides right through the weakness and participates fully in the inevitable subsequent recovery. Moreover, by not selling, the investor is spared the near impossible task of figuring out when to buy back in, and completely sidesteps the accompanying high risk of missing out on a material portion of the recovery that is a consequence of figuring out too late. This was the point of a Nexus blog from earlier this year And This, Too, Shall Pass.

There is another sense in which the successful long-term investor makes money in bear markets: with a high-quality portfolio that declines less than the market as a whole. By not losing as much as the market declines, this portfolio has less “lost ground” to recoup during the ensuing recovery. Thus, by merely keeping up with the market during the rebound – not outperforming it – the portfolio maintains its advantage. After a few such cycles of less-than-market declines and pace-keeping recoveries, the investor with this portfolio will be well ahead.

The last 6 months or so provide a good illustration of the point. In the last three months of 2018, the Canadian stock market, as represented by the S&P/TSX Composite, suffered a loss of more than 10%, including dividends. The S&P 500 fared no better. It gave up more than 13% when measured on the same basis, and nearly 9% in Canadian dollar terms.

Putting this in portfolio terms, a passive investor who held 5% of their portfolio in 91-day Government of Canada treasury bills, 50% in an index fund that perfectly mimicked the S&P/TSX Composite, and the remaining 45% in an index fund that cloned the S&P 500, would have had a loss of just over 9%. Just to get back to “even” the passive investor needs to earn a return of 9.9% on their now-diminished portfolio. By contrast, an actively-managed portfolio that lost less in the fourth quarter of 2018 – let’s say, 8% – needs to earn a return of “only” 8.7% to get back to even.

Like long-distance runners who fall off the pace, both the passive and active portfolios have some serious ground to make up. But the active portfolio that doesn’t fall as far off the pace as the passive one is better positioned. Continuing with (and perhaps stretching) our metaphor, our active runner/portfolio will finish ahead of the passive one, merely by running at the same pace.

The metaphorical active runner in our example is the Nexus North American Equity Fund over the last 7 months. It lost 8% in the last three months of 2018, at a time when its benchmark (the passive runner) lost 9%. Since January 1st, the benchmark has gained 15.9% to the end of April. The Fund didn’t quite keep pace, earning a “mere” 15.5% to the same date. However, over the full 7-month period, the Fund still came out ahead: up 6.2% versus 5.4% for the benchmark. By losing less than the market (as represented by the benchmark), the Fund outperformed the market over the sell-off and subsequent rally.

A period of only 7 months is an absurdly short timeframe for evaluating long-term portfolio performance – analogous to judging a 26-mile marathon based on how the runners fare between mile markers 6 and 7. But it illustrates the important principle that some of the biggest gains accrue when times are tough, and not when the tailwinds are favourable.