Saturday, March 28, 2009

How will the bear market end?

During bear markets, especially ones as severe as the current downturn, the obvious temptation for investors is to reduce their allocation to stocks and move into the safety of cash. A common refrain from investors is that they will "wait until things get better" to restore their allocation to stocks at a level that is consistent with their longer-term investment strategies. The criteria for improvement often implies the investor will hold out for some positive news about the economy, or possibly wait for the market to start rising again in a more sustained manner.

While this strategy may sound reasonable at a time when stock markets continue to decline and investors take comfort from avoiding losses, the flaws are exposed when the bear market comes to an end. As noted, the market tends to rise six months before the economy stops contracting, so waiting for good economic data to hit the headlines inevitably means missing out on the early stages of the rally. Of course, waiting for the stock market to go up as a signal of the end of the bear market also necessarily means an investor has to sit on the sidelines while a new bull market begins.

This pattern of investor behavior, and its pitfalls, can be demonstrated looking at the end of the 2000-2002 bear market (see MARE article, The Perils of Herding to Cash). Investors moved into a record-high cash position by the end of 2002, during the exact period when the U.S. stock market was bottoming after a three-year downturn (see Exhibit 2.) It took investors roughly until February 2004 -- 15 months after the end of the bear market -- to reduce their cash position back to an average level, during which time many had missed out on the stock market's return of more than 30% during the simultaneous bull market rebound.

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