Internal Reports

 

Surviving a Bear Market and Crisis Events

October 2001
by John Montgomery,
Bridgeway Capital Management, Inc.

 

Summary

There is a very strong temptation to try to avoid some of the "pain" of a bear market by selling stocks and keeping the money in cash during the downturn. Emotions, casual thinking about market timing, and much of the financial press reinforce this urge. However, there are a number of compelling reasons not to try to time the market even (and perhaps especially) in the wake of a crisis event, such as the terrorist attacks of September 11, 2001: 1) The statistical record of individuals trying to time the market is abysmal. 2) The statistical record of professionals trying to time the market is abysmal. 3) The record in event-driven (including war) market declines indicates that there is not a good opportunity to "cash out." 4) Market timing requires two correct calls (when to get out and when to get back in), not just one. 5) Market timing usually has a major negative effect on tax efficiency, i.e. an investor must send more of his or her investment return to the "tax man." 6) Market timing destroys value through increased transaction costs. There are some investment decisions that are of marginal importance; Bridgeway's research indicates that the decision whether or not to time the market is not one of them.

Introduction

As defined by a 20% drop in the S&P 500 Index, the U.S. entered a bear market in the first quarter of 2001, and economic conditions continued to deteriorate thereafter. Exacerbated by the terrorist attacks of September 11th and their aftermath, the U.S. economy officially entered a recession in the fourth quarter of 2001. Amid continued poor economic news, declaration of war by the President, and a sea of red ink in the stock market, some investors may be tempted to "throw in the towel" on stock market investing, or at least try to "wait out" the current negative environment by taking money out of stocks. The purpose of this paper is to inform investors by presenting Bridgeway's case against the practice of market timing and by offering encouragement to those "staying the course" in a bear market. However, nothing in this paper should be construed as investment advice, since each individual’s financial situation is unique.

Bridgeway's Investment Philosophy with Respect to Market Timing (Don't) and Asset Allocation (Do)

Bridgeway's philosophy about the degree and timing of market exposure is well defined and applied in a disciplined way in all market environments. As an investor in Bridgeway Portfolios, as a fund product designer and as a portfolio manager, I spend significant time "up front" deciding how much exposure to the stock market is appropriate. Once I make this decision, I try to implement it relentlessly and without emotion, in good times and in bad. (Not trying to second-guess these decisions has the added benefit of saving a tremendous amount of time.)

As an individual investor, I put no money in the stock market that I expect to spend in the next couple of years. I focus on short-term interest bearing investments with this money. I don't want to be caught having to sell stocks in a single large down market year in order to pay bills.¹ However, most of the money I don't plan to spend in the next ten years I do put in the stock market in a (fairly) diversified way through Bridgeway Funds. With this money, I plan to "ride out" market declines. I don't want to bear the risk of inflation decimating the purchase power of my investments over longer periods. Interest-bearing investments have been more vulnerable historically.² This strategy is the cornerstone of my asset allocation plan, which I keep in place through thick and through thin. My plan is exactly the same in bull and bear markets.

As a fund product designer, I think a great deal about asset allocation and risk. Bridgeway has some very high-octane portfolios, such as Aggressive Investors 1 and 2, Ultra-Small Company, and Micro-Cap Limited, which we expect to go down more than the market in a market decline. It also has some portfolios targeting more moderate short-term risk (for stock funds), such as Ultra-Large 35 Index, and one more conservative, the Balanced Fund. When we set the short-term risk target of the Balanced Fund, we built our target right into the portfolio investment objective (40% of the short-term stock market risk).

As portfolio manager, once this risk target is set in the design of a portfolio, I don't change it based on whether the market looks high or low. In other words, we target overall risk, but we don't change our implementation plan based on whether the market looks expensive (high) or cheap (low). I think market timing is a bad idea during a bear market or any market.

Event-Driven Market Declines

Much of the concern about the current market surrounds uncertainty following the September 11th terrorist attacks. It is natural to ask, "What happened to the market in other events of war, terrorism, or major uncertainty?" While the future never looks exactly like the past, history can inform our decisions with respect to risk.

In a number of major, event-driven market declines, the market returned to pre-event levels in a matter of months. After a one-year period, the numbers seem fairly compelling. If anything, I would conclude that historically the "horse has already left the barn" by the time an investor has an opportunity to sell. There is still much uncertainty as to whether there will be additional successful terrorist attacks, so I don't expect a full recovery right away. (On the other hand, one could conclude from the table below that factors other than the "major event" end up driving stock prices.) However, the more we get back on a normal track, the more I expect the stock market to recover. Personally, I don't believe this is the time to abandon a well-designed investment strategy that includes stocks. It also doesn't mean that the stock market can't decline further; it can. Here are the historical details.

Market Turmoil & The Dow Jones Industrial Average*

Date		Event	Short Term % Change	1 Month % Change	3 Months % Change	6 Months % Change
9/11/2001		Attack on America	-7.1	-3.8	?	?
Political/Economic Uncertainty
9/24/1955		Eisenhower heart attack	-6.5	-6	-0.2	5.1
11/22/1963		Kennedy Assassinated	-2.9	3.8	8.7	12
10/17/1973		Arab Oil Embargo	-0.5	-9.6	-11.5	-10.3
10/19/1987		Financial Panic '87	-22.6	-14.4	-12.6	-10.6
8/18/1991		Gorbachev Coup	-2.4	1.7	3.2	9.4
10/27/1997		Asian Stock Market Crisis	-7.2	8.8	10.5	25
		Average	-7	-2.6	-0.3	5.1
Acts of War/Terrorism
9/16/1920		Bombing at JP Morgan Office	-5.5	-4.3	-12.9	-12.2
5/10/1940		Germany invades France	-2.3	-23.6	-17.9	-9.9
12/7/1941		Japan attacks Pearl Harbor	-3.5	-2.4	-9.6	-16
6/25/1950		Korean War	-4.7	-8.9	1	2.2
10/21/1962		Cuban Missile Crisis	-0.8	11.2	17.8	24.7
8/2/1990		Iraq invades Kuwait	-1.2	-9.8	-15.6	-6.4
2/26/1993		World Trade Center Bombing	0.2	2.7	5.2	8.5
8/7/1998		U.S. Embassy Bombings Africa	0.2	-6.5	2.4	8.5
		Average	-2.2	-5.2	-3.7	-0.1

* Some of the information in this table is based on data from and used with the permission of Ned Davis Research, Inc.

It's Nearly Impossible to Come Out Ahead When Trying to Time the Market

Timing the market successfully is incredibly difficult, based on a number of studies and my own research. To illustrate, let's go back to August of 1987 and suppose you exactly timed exiting the market before the October '87 "crash." Now, when do you get back in? I remember looking at charts that overlaid the first two months of the '87 correction with the Great Depression crash of 1929-31. The remarkable similarities indicated that you should stay out of the market a full two years. As we know from hindsight, however, the 1987 market started to recover in December, just two months after the "crash." Unfortunately, timing the market involves calling it right twice, not just once, and that's nearly impossible.

Most Individuals Don't Come Out Ahead When Trying to Time the Market

Peter Lynch made an astonishing statement about a trend during his time as portfolio manager of the Fidelity Magellan Fund. Although Magellan had a fantastic record of beating the market during his tenure, too large a percentage of investors in his fund actually lost money. They tended to buy after a significant runup, but sold during down periods which is a formula for horrible investment results. This phenomenon has been documented by two studies in financial magazines and by at least one academic study. Wilshire Associates' Stephen Nesbitt studied the gap between portfolio returns and shareholder returns from January 1984 through August 1994 and found that investors’ returns were 1.1% less than the average 11.0% return of their funds. Bridgeway studied the record of some market timers who found their way into one of our portfolios earlier this year and also found that they lost money as a group. (We strongly discourage all market timers from investing in our portfolios and bar short-term investors from investing again.) Based on all the studies I have read, market timers play a "loser's game."

Most Professionals Don't Come Out Ahead When Trying to Time the Market Either

You might be thinking, "Well, I can't time the market successfully, but surely there are professionals who do." The record on professionals timing the market is just as abysmal. Five years ago I studied 90 professionals who offer advice on timing the market. Only seven (8%) beat a buy-and-hold strategy, according to data published by the Hulbert Financial Digest. Five of 42 (12%) beat the market over the prior ten-year period. The percentages tend to get worse for longer time periods. Only one in 17 market-timing newsletters beat the market over the previous 15-year period. As a test, I even tried focusing on the best market timers. I went back to 1992 and chose the only four market timers who had beaten the market over the previous five or 10 years and pretended to follow their advice through for the next five years. Unfortunately, not a single one of these advisors had beaten the market over this period. I recently updated this analysis. I went back to 1998 (the last time I performed the analysis) and again picked the four professional timers who had beaten the market over the previous five years at that time. How did they do in the recent market downturn? One actually beat the market, but only by 0.2%. One appeared to be out of business. The other two had records that declined more than the market. What's remarkable to me about this is that if you're timing the market and spend any time out of the market in a bear market, you'd expect to do better than the market. No so here. I believe the record of professionals timing the market is abysmal.

Down Markets—Chances for a "Three-peat"

Although the stock market has declined about one in four years on average since 1926, the number of occurrences of back-to-back declines has been infrequent. The markets of 1973 and '74 are the only cases since World War II. The next year, the S&P 500 Index rose 37%. I can't guarantee that next year, 2002, won't be a third straight down year, but I don't believe it is prudent to risk missing the market in an atmosphere in which recovery could occur rapidly.

The Tax Man

Another very bad thing about timing the market in a taxable account is that, on average, it gives Uncle Sam a bigger piece of your investment pie sooner. In other words, the increased buying and selling creates more capital gains at higher tax rates; your "after-tax" return is lower than it would be otherwise. Think about the one professional market timer who beat the market slightly in the second time period analyzed above: Even if you were fortunate enough to choose this timer, you would have come out significantly behind the market after paying taxes.

Transaction Costs

Apart from taxes, timing the market increases transaction costs, which typically further deteriorates investment returns. Bridgeway estimates that the transaction costs of the "average" mutual fund are as high as the expense ratio of the fund. Like the tax effect of market timing, the transaction cost effect is strongly negative in most cases.

Much of the Financial Press is Working Against You

Much of the financial press does a big disservice to investors by reporting every slight move of the market. They have to sell their product, so they have to find something to say. Actually, in a sense, we feel we’re doing our shareholders a disservice by highlighting account balances and performance each quarter. The report focuses attention on short-term performance, which is potentially counter-productive. I realize I'm in a very small minority by holding this view. Let's apply this logic to another asset class.

For many people, their house is their biggest asset. I frequently wonder what decisions people might make if they could look up the market value of their home each day in the Wall Street Journal. Would they get ulcers trying to factor in the changes in their net worth? Would they consider selling at the top and renting for a couple of years (only to find out they probably sold closer to the bottom)? Would they increase their mortgage and build an addition in an up market, only to find themselves too burdened with debt in the next recession? Perhaps many fewer people would own homes, because it would be so much more strenuous. As ludicrous as this sounds, why is the stock market any different?

Peter Lynch also shares an interesting anecdote about not panicking in a down market. He refers to this as the Rip Van Winkle theory of investing. Quoting an ad campaign of the 1980s:

When "Broker X" talks, everybody is supposed to be listening, but that's just the problem. Everybody ought to be trying to fall asleep. When it comes to predicting the market, the important skill here is not listening, it's snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. ... If not, your only hope for increasing your net worth may be to adopt J. Paul Getty's surefire formula for financial success: "Rise early, work hard, strike oil."

                                           Peter Lynch, One Up on Wall Street

Conclusion

To conclude, too much is working against trying to time the market: emotions, much of the financial press, transaction costs, taxes, and the need to call it right not once, but twice. Add to that list a compelling and growing body of research that indicates that both professionals and individuals destroy value by trying to time the market. There are many investment decisions that are marginal; Bridgeway's research indicates that market-timing is not one of them.

__________________

¹ Of the six (large stock) market declines of at least 20% (based on month-end data) over the last seven and a half decades, the average market downturn (from peak back to the value of the previous peak) was 2.5 years excluding the Great Depression (or 4.6 years including it). The shortest was 16 months. The longest was 3.4 years (or 15.4 years excluding the Great Depression). One risk of being out of the market is that you miss a rapid recovery forever. However, this doesn't guarantee that your investment will reach its previous peak in just a year or two. As of October, we are 14 months into a bear market defined in this way.

² For example, if you wanted to invest your "nest egg" responsibly and safely in 1940, the last place you would probably have put it was in the stock market, having just lived through the Great Depression. U.S. Treasury bills are known as the ultimate "risk free" investment, since they are backed by the full economic power of the U.S. Government. However, no investment is risk free, since you can't spend "pre-inflation" dollars. Your investment in T-bills would have increased slightly each month from 1940 over the next 10 years. Actually, you might have been lulled into a false sense of security, because the purchase power of that money (with interest reinvested) actually declined 41% over the next 10 years. A 41% decline in the stock market would get your attention, and you should be concerned about a potential 41% drop in the purchase power of your money also. Stocks have tended to be a better inflation hedge over longer periods.