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On the brink of a bear market – what you should do next: Editor’s Note

Emma Rapaport  |  17 May 2022Text size  Decrease  Increase  |  
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I did the thing you’re not meant to do last week. As the ASX 200 nosed dived 2.5% on Tuesday morning, I checked my portfolio. Ooft. Much worse than I expected. I looked again on Wednesday, Thursday and Friday as the US market flirted with bear market territory. Around half the paper gains I made in the 2020 market rebound have vanished – now distant memories of a monstrously bullish run. My bonds have done even worse, suffering as the US bond market enters the worst bear market in at least 28 years, if not ever. So much for a portfolio diversifier.

We’ve been talking for some time about the macroeconomic machinations putting the fear of god into equity markets across the globe, but there was a marked shift in tone this week. The ‘R-word’ screamed across headlines after Federal Reserve chairman Jerome Powell said that getting inflation under control without triggering a recession won’t be easy, even if he still believes the bank can do it.

“If push comes to shove, Powell conceded that getting inflation under control remains his top current priority – even at the risk of a Volker-style recession similar to that of the early 1980s,” noted BetaShares chief economist David Bassanese.

Investors are now positioning themselves for the possibility central banks will shove the global economy into a recession in their rush to raise rates. That meant a big selloff in equity markets.

The Fed is walking a tightrope,” says Morningstar’s Christine Benz. “If they raise interest rates too far, too fast, the risk is that is going to disincentivise economic production, that people will borrow less, they will do less, and that will put the brakes on the economy. That's a big risk factor.

“The other risk is inflation. If consumers pull back on spending, that could contribute to a recessionary environment.”

US Market Downturns, Recoveries and Expansions

Faced with the prospect of a lengthy downturn, it’s time for resilience in minds and portfolios – the grit to respond in a way that not only allows us to survive but prosper. As the great value investor Shelby Cullom Davis famously said, "You make most of your money during a bear market; you just don't realise it at the time."

Resist the urge to panic

The first and most obvious thing is to say that it’s rarely wise to be a seller in these environments (if you can avoid it). Selling into a downturn violates one of the key tenets of successful investing: buy low sell high. “Even the emotional relief that selling might bring is fleeting, as it’s so often quickly replaced by another nagging worry: Is it time to get back in?” says Benz. Anyone who tries to trick the bear by selling investments and piling up cash will likely suffer less-than-perfect timing and miss out on big stock-market gains, as many learned the hard way in March and April of 2020.

Yes, markets could keep going down, but those with long-term investing horizons (10 or 20 years) and broadly diversified portfolios, are more than likely to make back losses. I’m not saying that will happen next week – it could take a decade (or more), but history shows markets rebound, eventually.

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That’s not to say there aren’t good reasons to sell stocks. As Benz writes, recommending investors ‘stay the course’ assumes the underlying investment plan and asset allocation are well-thought-out.

“At least until recently, we were living in an era of FOMO in which many novice investors barrelled into risky assets with the hopes of overnight riches,” she says.

Older investors too may have strayed from their financial plans as stocks enjoyed a decade of growth and rebalancing was put on hold/delayed. That said, there are three good reasons to sell stocks now – namely for those nearing retirement (who don’t have enough in cash or defensive assets to tide you through a long-downturn), those with short-term investment goals, or those who know they’ll capitulate if things get worse. Read more: 3 good reasons to sell stocks now

MORE ON THIS TOPIC: What prior market crashes can teach us about navigating the current one 3 charts on why you should stay the course during turmoil 

Look for quality bargains, particularly in US tech

Second, if your portfolio is dominated by US tech and growth stocks, you’re in for a wild ride. It’s been a remarkable turn of events with shareholders of the most dominant, innovative companies on the planet suffering losses of 30% or 40% in the span of just a few months. Big names on the board include Microsoft (MSFT) off 22%, Apple (AAPL) down 17%, Google parent Alphabet (GOOGL) shedding 22%, Netflix (NFLX) tumbling a stunning 73%. How the mighty have fallen.

Tech stock bear market

Change requires a catalyst. In this case, it was the abrupt realisation that the US Federal Reserve was going to move aggressively to raise interest rates, writes Morningstar's Tom Lauricella. Technology and growth stocks are generally seen as most vulnerable to higher rates because they are so reliant on future cash flows. Investors use interest rates to discount the value of those future earnings back to today, and higher rates today diminish the value of future earnings.

There’s no guarantee these names will return to their former glory – especially when the valuation gap between what a company is worth (on standard metrics) and what people are willing to pay for it got so out of whack. But investors playing the long game can use pullbacks as a chance to increase positions in existing holdings on the cheap or initiate new positions. Strong balance sheets, ample free cash flow generation, high-profit margins and returns on invested capital - these are all signs of high-quality businesses.

“The bad companies are getting thrown by the wayside. Good companies are getting punished too, but they’re getting punished because they had huge valuations attached to them that were unsustainable,” Steve Sosnick, chief strategist at Interactive Brokers tells Lauricella. “You have to take the longer-term view. The good companies are still good companies.”

View  Morningstar’s Best Stock Ideas.

Return to the plan

Third, if you’ve been a bit lazy with your financial plan recently – I know I have with everything opening back up again – now is the time to revisit. Or if you haven’t made a plan, make one – go on, I dare you. Having a financial plan ensures every investment has a purpose and keeps you on track in a downturn. Rather than scratching around for which stock or ETF to buy, a plan starts by defining your financial goals (what and by when), setting a realistic required rate of return to reach those goals and only then do you select investments to get you there. It also ensures you have enough cash on the side to ensure you don’t have to sell into a downturn to fund retirement needs.

When the market drops, your required rate of return will adjust. For example, if you needed a 7% return annually and the market jumps by 20% for two years in a row, you don’t need to be as aggressive for the subsequent years – let’s say your required rate of return is now 4%. But, if the market drops 30% the next year, perhaps by rate increases to 5% or 6% - nothing out of this world – so you don’t have to make any changes to your portfolio. A plan prevents you from making emotion-driven decisions.

For more on constructing a goals-based portfolio: Podcast Webinar

For more on what you should do in volatile times: Your market downturn toolkit Risk, not volatility, is the real enemy What to do (and not do) in a volatile market

Open your mind

Fourth, now is the time to educate yourself. If you started investing in the last decade, chances are you’re facing economic conditions you’ve never seen before – rising rates, hawkish central banks, sky-high inflation and talk of recession. Even those of you who remember the 2000s tech crash or 1970s stagflation are likely a bit rusty. Take some time to understand what just happened, the types of investments and companies that perform well in bear-markets (although each slump brings its own new twists), and seek out different perspectives on the market. Morningstar’s Mark Lamonica believes things are about to get much worse, made harder by the inflexibility of central banks to respond, while others point to record low unemployment, cashed up households and the belief that inflation will ease of its own accord.

If you’re young enough, moments like this are going to happen again through your investing life. Reading about a crash is one thing, living through it is another. Training yourself to understand what’s going on around you and your own emotional reaction will help you when the next downturn hits.  

Finally, just because it’s harder doesn’t mean you should quit the market for good. Let's face it--investing has its risks, one of which is losing money. It's going to happen from time to time. If you have the capacity to grin and bear it, I recommend you do just that. I promise to stop torturing myself with my on-screen losses.

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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