4 Ways to Prepare For the Next Bear Market

by James Parkyn

They say hindsight is 20/20 and that’s never truer than when it comes to the stock market.

When looking back at past corrections and bear markets, it’s natural to see all the factors that led to the downturn. However, the picture is much foggier when you’re trying to figure out when the next one might happen.

In fact, the evidence is that no one can consistently forecast the future direction of the markets – either up or down. Of course, this doesn’t prevent analysts, media pundits and investors from trying to predict the next crash.

As we’ve observed in recent episodes of our Capital Topics podcast, the doomsayers have been particularly vocal of late. They’re saying we are headed for a stock market correction or even a bear market because of the relatively high valuation levels of the markets.

The equities markets have had a strong run. For example, the U.S. market’s total return over the 10 years to January 31 was 17.8%, more than double the long-term expected return. However, experience teaches us that relative valuation metrics tell us very little about the timing of market pullback.

What are corrections and bear markets? A market correction is a drop of 10% to 20% from a recent peak. They usually don’t last very long. After a few weeks or months, the market recovers the losses. Corrections are quite normal; they allow the market to consolidate and take a breather before going higher.

A bear market is more serious. It’s when markets drop more than 20% from their recent highs. They usually last much longer. The triggers for a bear market vary greatly, but they are generally related to poor economic data, a geopolitical crisis or the bursting of a market bubble.

Since 1926, the S&P 500 has experienced 17 bear markets with declines ranging from -21% to -80%, according to this report from Dimensional. The average length of these bear markets was 10 months. The longest bear market was in the early 1930s, lasting 27 months, and the shortest one was the COVID crash two years ago. It lasted just one month.

As humans, we’re not wired for negative market volatility. Behavioural science has demonstrated it triggers our fight or flight instinct, and that’s why investors often make wealth destroying errors during a downturn.

Bear markets are when Investors learn their true tolerance to risk. For the long-term investor, they’re actually a time of great opportunity. But for those who panic, they almost always lead to a permanent loss of capital. That’s why it is crucial to be mentally prepared. A big drop may not happen tomorrow, this month or this year, but you can be sure one will occur sooner or later.

So, how should you prepare yourself for the next drop?

• Have a plan—You won’t be surprised by this piece of advice. You need to have an investment plan that you’ve laid out when the markets were calm and your emotions were in check. The plan must take into consideration your need and willingness to take risk as well as your time horizon. Remember that taking too much risk may lead you to bail out of the markets at the wrong time.

• Have a safe bucket—The best way to reduce risk in your portfolio is to have an allocation to high-quality short duration bonds. This safe bucket should be built with government and other top-quality bonds. Bonds hold their value in a bear market and may even gain, offsetting some of the losses in your equity bucket. If you are a retiree pulling money from your portfolios for living expenses, our advice is to have enough money invested in bonds to cover five or more years of annual withdrawals. This will help you stay the course until equities recover.

• Rebalance regularly—Rebalancing ensures your portfolio reflects your risk profile and capacity for risk. This is especially important during a prolonged bull market when many investors grow comfortable holding a larger percentage of stocks in their portfolios

• Tune out the noise—Finally, keep your emotions in check by tuning out the media noise. Embrace the fact that corrections and bear markets are unavoidable and unpredictable. One day they will end. Remember that if you stay disciplined and stick to your long-term investment plan in a bear market, you will be rewarded when the next bull market comes around.

Don't Fall Victim to Anxiety about Where the Market is Headed

By James Parkyn

When it comes to the stock market, some investors seem to believe in the old adage “what goes up must come down.” They worry that after such an outstanding year in the markets, we must be headed for a fall. This month’s downturn is no doubt feeding those fears.

One way this kind of thinking manifests itself is in a reluctance to invest new money in equities because the market is “too high.” Other investors take it a step further and actually sell stock with the intention of buying back in “after the correction, when prices are more reasonable.”

Before the recent bout of turbulence, the stock market had provided exceptional returns dating back to pandemic crash in February and March 2020. In 2021, the Canadian market was ahead 25.1%, its best year since 2009, while the U.S. market produced a Canadian dollar return of 24.6%.

The 2021 gains put equity valuations at relatively high levels, according to such metrics as the Shiller CAPE 10. However, the same observation was made at the beginning of 2021. Then, the S&P 500 went on to make 70 all-time highs during the year.

As author Larry Swedroe notes in this article, valuation metrics shouldn’t be used to try to time markets. “While higher valuations do forecast lower future expected returns, that doesn’t mean you can use that information to time markets,” Swedroe writes. “And you should not try to do so, as the evidence shows such efforts are likely to fail.”

The advice is equally true for market pullbacks and the days when markets hit an all-time high. These periods are often the trigger for the media and individual investors to start speculating about how portfolios should be readjusted on the fly. That’s when people make wealth-destroying errors.

The danger of succumbing to anxiety by selling equities or holding off on new investments is two-fold. First, you will have to make the thorny decision of when it’s safe to get back into the market. Second, you risk missing out on strong returns while you’re sitting on the sidelines. If you want to know how that feels, just ask anyone who sat out 2021.

When it comes to investing, the antidote for unhealthy emotions is a long-term financial plan with asset allocation targets that reflect your objectives and risk tolerance. As the markets move up or down, you periodically rebalance your portfolio back to your target asset allocations and keep your faith that the process works over time.

Your goal should be to cultivate a long-term investor mindset. Long-term investors ignore the day-to-day noise that comes with volatility and stick to their plan with discipline.

High Hopes for Future Returns Can Cloud an Investor’s Judgment

by James Parkyn

It’s been another outstanding year in the stock market. We will have the final performance numbers for you in the new year, but equities have continued a remarkable run that started in March 2020 when the COVID crash hit bottom.

While the strong results are certainly welcome, they appear to have conditioned many investors to hold unrealistic expectations about their future investment returns.

That’s the key conclusion from a survey of 8,500 individual investors in 24 countries and 2,700 financial professionals in 16 countries conducted by Natixis Investment Managers, a French financial services firm with US$1.4 trillion under management.

The survey found a huge gap between the returns individual investors expect to earn over the long term and what financial professionals say is realistic. Globally, investors anticipate annual returns of 14.5% over inflation while the financial professionals said 5.3% over inflation is realistic—that’s a whopping 174% difference.

Canadian investors were somewhat more conservative than their global peers, according to the survey. Individual investors in Canada expected annual long-term gains of 11.2% over inflation while financial professionals believed realistic returns for their clients were 5.1% a year.

By contrast, U.S. investors were even more aggressive in their return expectations than the global average. American investors anticipated 17.5% annual returns above inflation compared with the 6.7% financial professional said is realistic.

The research team at PWL uses an evidence-based approach for setting expectations for future returns for various asset classes and inflation. In our Financial Planning Assumptions paper, published in October, we estimated expected annual returns from a 60/40 equity/bond portfolio to be 4.86% above inflation.

Why are investors so optimistic about future returns? We can attribute it to what’s known as recency bias—a common error in thinking that leads people to give greater importance to recent events.

Clearly, many investors have grown accustomed to excellent portfolio performance. Even before the powerful rally that began in the early weeks of the pandemic, returns had been strong ever since the 2008-09 financial crisis. This has led them to expect it to continue and get even better in the future.

In the Natixis survey, investors identified market volatility as their No. 1 concern, yet their elevated return expectations suggest they’ve become desensitized to risk. We see this in a growing appetite for risky investments such as tech stocks, cryptocurrencies and special purpose acquisition companies (SPACs).

However, capital market history, valuation metrics and common sense suggest we should be tempering our return expectations after such a long period of exceptional performance, not ratcheting them up.

We are careful to control risk for our clients through broad diversification and periodic portfolio rebalancing. No one can predict what the future holds, but a patient, realistic view is the best way to build wealth over the long term.

As the year comes to a close, Francois and the whole PWL team join me in wishing you a happy holiday season and a healthy and prosperous 2022. We look forward to reviewing your portfolio with you in the new year.

Acting in the best interests of clients

by James Parkyn

Some of Canada’s big banks took quite a lot of criticism recently for their decision to stop selling mutual funds from outside companies through their financial planning arms.

CIBC, RBC and TD claim the decision to allow financial planners to sell only inhouse funds is in response to new regulations that come into effect at the end of this year. Those regulations are known as know your product (KYP) and are part of a larger package of client-focused reforms (CFRs) being brought in by the country’s securities regulators.

The KYP rules are designed to ensure investment firms and their advisors have a deep knowledge of the products they recommend to clients.

For firms, this means having policies, procedures and controls in place to monitor investments offered to clients and providing training to advisors on them. For advisors, it means recommending only firm-approved investments and demonstrating they understand what they are recommending and ensuring they are suitable for a client’s portfolio.

The overall goal of the client-focused reforms is to create a higher standard of advisor conduct that will put clients’ interests first. Essentially, it could be viewed as a codification and enhancement of industry best practices that many firms and advisors are already incorporating—from gathering detailed client information to demonstrating product knowledge to revealing potential conflicts and putting clients’ interests first.

The decision by the three big banks to stop selling third-party mutual funds sparked an outcry from critics in the media and the financial industry who say the banks are not acting in the best interests of their clients. They argue the banks are using the new rules as an excuse to sell only their own funds, which are more profitable for them, through financial planners in branches. (Third-party funds will still be sold by the banks’ full-service brokers and their online discount brokerages.)

Globe and Mail columnist Rob Carrick noted the banks are depriving investors of the opportunity to choose better alternatives available from third-party fund companies and said the three big banks are “effectively turning their planners into sellers of bank products.”

For my part, I hope the actions of these three big banks will lead clients to reflect on what they want and should expect from their investment advisor.

The country’s securities regulators introduced the new client-focused reforms after resisting calls to bring in the more rigorous fiduciary standard for investment firms in the face of stiff opposition from the industry.

At PWL Capital, we have long adhered to a fiduciary standard in our client dealings and have argued it should be applied throughout our industry. Under a fiduciary standard, a firm must put its client’s interests above its own and act strictly in a client’s best interest.

For many years, our firm has been accredited by the Centre for Fiduciary Excellence (CEFEX), a global organization that audits and certifies the processes of investment advisory firms.

CEFEX-accredited firms adhere to the Global Fiduciary Standard of Excellence. To obtain this accreditation, PWL was required to undergo an extensive “best interest” review—and, to maintain this status, we must undergo annual audits by CEFEX.

At PWL, we don’t have any in-house products. We have a list of approved securities that includes only investments that have been researched by the firm and approved by our investment committee.

These investments are all low fee and tax efficient. They offer no compensation to PWL, or the firm’s advisors, and they reflect our philosophy that passive portfolios and broad diversification are the keys to long-term investing success.

In all these ways, we demonstrate our steadfast belief that investment advisors must always act in the best interests of their clients. It is the bedrock upon which our firm is built.

Why worry about whether we’re in another speculative bubble?

by James Parkyn

It’s been almost a year since the World Health Organization declared a global pandemic in response to the spread of COVID-19. As we discussed in our recent portfolio performance review 2020, no one could have predicted the extraordinary events of the past year or the markets reaction to them.

The market crash in February and March 2020 was the worst since 1929 as the gravity of the pandemic crisis became clear. Then, the markets came roaring back with extraordinary speed and ended the year at all-time highs.

It was a year like none other in memory and provided a remarkable lesson on the importance of disciplined asset allocation and the danger of trying to outguess the markets by jumping in and out of investments in hopes of cutting your losses or maximizing your gains.

That’s called market timing and researchers have found it to be one of the worst wealth-destroying mistakes you can make. For example, the Dalbar research firm found that poor trading decisions caused the average U.S. equity fund investor to earn annual returns that were 4.7 percentage points below those from the S&P 500 index in the 20 years to the end of 2015.

People who try to time the market are often driven by a fear of losses or a desire to make big profits, but as we’ve seen in dramatic fashion this year, it’s impossible to forecast where the markets are headed.

The danger becomes clearer when we dig a little deeper into recent market trends. Growth stocks in general—and big tech stocks in particular—produced by far the best results in 2020. In the U.S., large and mid-cap growth stocks returned 36% versus just 1% for value stocks—the largest divergence ever recorded.

Skyrocketing prices have captured the imaginations of many investors who have bought into tech stocks and other hot investments like electric car maker Tesla and cryptocurrency Bitcoin. Meanwhile, others are dumping their stocks because they fear a speculative bubble has inflated of the kind seen during the dot.com era of the late 1990s.

Which side is right? A rational investor doesn’t have to engage with either. The antidote to the stress of worrying about current market conditions is a portfolio that is broadly diversified across asset classes and geographies and a patient, long-term perspective.

We make no judgment about whether U.S. growth stocks are in a bubble, but we do observe that value stocks and markets in other parts of the world are currently trading at far lower valuations. The beauty of diversification is that when one market is falling, others will be performing relatively better.

The real danger in investing is not missing out on a hot sector bet or suffering through a market correction. It’s making poor decisions in the heat of the moment that can lead to a permanent loss of capital.

Our discipline of sticking to diversified asset allocation may not produce the excitement of jumping on the latest zooming tech stock or cryptocurrency, but it has been proven to be the prudent way to build wealth over the long term.