Bear market investing

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3. Why do bear markets happen?

John Rothchild's quote (right) tells you what is happening when a bear market is in progress - sellers outnumber buyers - but there's a critical difference between the January sales at Selfridges and an equity bear market.

• Retail Sales are planned, orderly, not sparked by mass anxiety, and controllable. The sellers decide the prices, and they have the power to end the bear market when they want.
• Equity bear markets are unplanned, disorderly, infused with anxiety, and not controllable by any one person or group of people.

Why do they happen? There can be lots of reasons:

1. Realisation that the fundamentals are unrealistic

   This is a version of The Emperor's Clothes. When companies are trading on P/E ratios of 30+, investors are being asked to pay an amount which will take thirty years to recover. In a bull market, they go along with the joke because everyone else is. At some point the consensus changes.

2. Economic fundamentals

   Real bear markets, the ones that last a year or more, tend to be caused by, and in turn cause economic downturn. There's a logical reason for this:

   • share prices are ultimately determined by corporate earnings
   • companies only make earnings if people buy their goods and services
   • people spend more on goods and services if they feel confident about the economy

   It's a circular process which works both ways.

   Working forwards: if people feel confident about the economy, they tend to spend more and save less, which means companies make higher profits, which means share prices go up, which means people feel more confident about the economy, which means . . .

   Working backwards: if people don't feel confident about the economy, they tend to save more and spend less, which means companies make lower profits, which means share prices go down, which means people feel less confident about the economy, which means . . .

   The mystery is: what makes an economy that has been going forwards change direction and go backwards? That's a huge question, beyond the scope of this course, but the factors to pay attention to include:

   • Money in the economy
     Through monetary and fiscal measures, governments can either encourage or tighten consumer spending. One explanation for the bubble in US share prices in 1999 and the puncturing in 2000 is that the Federal Reserve increased the money supply before the Millennium then decreased it. And the impact was felt on Main Street.
   • Household savings
     The more people save, the less they spend, and vice versa. So savings behaviour has a big effect on economies. When people feel confident about their jobs, and well-off because of rising share prices, and the cost of borrowing is cheap, their spending tends to be high relative to savings. When confidence is low, and share prices dip, and inflation starts to climb, the reverse is true. Savings habits can provide foresight of corporate profits.
   • Corporate debt
     It has been a general trend for companies, particularly in the US, to increase their borrowings. This is partly because it was cheaper to raise money this way than by issuing shares. In an economic downturn, companies find it more difficult to take on debt or refinance existing borrowings. This can lead to crises of confidence and an adverse impact on share prices.
3. Political events

   Often major political events cause bear markets. In 1973-1974 the Middle Eastern oil embargo, together with Watergate and the Yom Kippur War shattered Western confidence. In 1990, Sadam's invasion of Kuwait did the same. The Vietnam War and the Falklands War took their toll.

   Wars in general have not been good for stock markets, contradicting the Rothschild maxim 'Buy to the sound of cannons. Sell to the sound of trumpets.'

   The depth of an event-inspired bear market seems to depend on how the event pans out. The quadrupling of oil prices caused a severe bear market because it had real economic impact. Sadam's invasion of Kuwait did not, because militarily he was quickly ejected.

1. A word on bears 2. What is a bear market? 3. Why do bear markets happen? 4. How to spot the appearance of a bear market 5. How bear markets end 6. Bear market investment options: timing the market 7. Bear market investment options: the asset classes 8. Stocks: blue chips vs small caps 9. Bonds 10. Property and gold 11. Cash 12. Stocks: general principles 13. Bear-proofing - low 'beta' stocks 14. Bear-proofing - high yield shares 15. Bear-proofing - sectors that historically do well in bear markets 16. Bear-proofing - sectors that historically do badly in bear markets 17. Bear-proofing - key ratios for selecting stocks 18. Bear-proofing - investing in stocks you know and can support 19. Bear-proofing - pound cost averaging 20. Recognising the revival - a check list 21. Conclusion

• The Bear Book
• Stan Weinstein's Secrets for Profiting in Bull and Bear Markets
• The Great Crash, 1929