Guarding Against the Bear

The compound annual growth rate of the S&P 500 between 1982 and 1999 was 22.4%. If the index gained nothing over the next seven years, it would still match the market's historical gain of 11% for the period of 1982-2008. Though many wags continue to beat the drum of a quick recovery, the reality is that a long bear market has precedence and is a logical result of the enormous debt loads and bad investments of the 1990s. Most investors are unprepared.

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By Bill Mann (TMF Otter)
September 5, 2001

It is taken by many investors as gospel that the market, as measured by the S&P 500 index, will go up an average of 11% per year. Well, what if it doesn't? All too many financial gurus are out there predicting rebounds by the second quarter of next year, the fourth quarter of next year, or whatever, but let's cut to the chase right now: These people have no idea what they are talking about.

There, I said it. Those who some are counting on for confidence as they navigate the choppy waters of a bear market don't know squat. If they did, where were they in March 2000? Oh, there were a few out there warning about a drop; not just perma-bears like Bill Fleckenstein, but also certain prominent market wags like Morgan Stanley's Barton Biggs.

And even Biggs was early with his call, so he looked mighty goofy for two years or so saying the market was gonna fall during the most insane rise in several generations. Finally, it did what he said it would: He had the eventual outcome right, but his timing was way off.

And now we're here hoping and praying that these same strategists cannot only tell us if the market is going to rebound but also tell us when it's going to happen? If you have participated in the market for more than two years and consider these guesses to be credible, brother, I've got some real estate in Freedonia I'd like to sell you.

Let's look at a doomsday scenario for a minute. What happens if the stock market does not come back anytime soon? How would you invest if you knew in advance that this was going to be the case?

I consider the scenario to be within the realm of possibilities, because it has happened before: The S&P 500 hit 109 in November 1968, but sat at that same level in August 1982, almost 14 years later. Further, we are just exiting a period of some of the most inefficient deployment of investment capital the world has ever seen. These things, when they happen, need time to work their way through. People overuse the term "hangover," but that's exactly what it is, and the only real cure is time. (And coffee.)

What if our bear settles in?
Over the 16 years between 1982 and 1999, the compounded average return of the S&P 500 index was 22.4%. Even after the 30% drop from its all-time high, the S&P 500 could gain nothing over the next seven years and still be above that magical 11% compounded growth rate since 1982. So what if it does? Are you going to have the patience to wait it out?

Some people will not. They demand growth, and soon, lest they get discouraged. But the stock market is NOT easy money, nor is it guaranteed to go up. In a prolonged weak market, hundreds of weak companies will cease to exist as their sales levels will not be sufficient to meet their debt obligations.

Take a look at your portfolio. Are you comfortable holding the companies for an extended period of time without appreciation of those assets? If you can't visualize holding a company for a decade, you shouldn't hold it for a minute.

I have good reason for covering the possibility of a long-term bear market now: For the first time in a decade, people are scared about their investments. With every passing day, it seems I hear of more and more people who are heading for the hills, selling out their portfolios in disgust. There are others who are desperate for someone to blame for what have turned into massive losses. At some point we have to face reality: A significant subset of people are emotionally unsuited for the pressure of holding individual equities.

The self-awareness that comes with adversity is not necessarily bad. Few people are capable of the same kind of introspection when things are going great. But there should be no doubt: Prolonged down markets provide almost unparalleled opportunity for the conservative and patient investor.

This is exactly how the prudent investor should view a long downturn in stock values: as an opportunity. Once this is all said and done, the best companies will have fallen into the smart investors' hands. Unfortunately, too many of us have fallen into the trap of letting short-term market moves tell us what is "quality" and what isn't. Billions of dollars were wasted chasing hundreds of companies like JDS Uniphase (Nasdaq: JDSU) when they were priced beyond perfection. Same with eBay (Nasdaq: EBAY), which STILL may be priced to perfection -- though it has the distinct benefit of having been nearly perfect to date.

So I say to you again -- forget the market, Fool! If anything should have been made clear by now, it is this: No one can control the market. Knowing that, are you buying companies that are built to withstand a bomb blast, at prices that mean even if the bomb hits, you will be OK?

If you are uneasy about making that determination, I suggest you take a look at putting your investment money into an index fund. With an index fund in the above scenario -- seven years of zero growth -- you would receive nothing but dividends over the next seven years, but that's a damn sight better than watching your investments dwindle to nothing with you paralyzed by fear.

The crowd won't save you
Above all, avoid the herd. Now that the technology market has crashed, said herd is not as concentrated as it once was, but sectors like oil and gas and REITs have suddenly gotten much more attention and have enjoyed some substantial gains. Unfortunately, in a crashing economy, neither of these two sectors will remain unaffected. Again, the strategy must be: Buy great companies at a good price. While both of these sectors will remain important for years to come, there aren't many bargains amongst them now. On the other hand, in a flat market those dividend yields for the REITs will begin to look awfully attractive.

As far as I'm concerned, there are few better values out there than American Express (NYSE: AXP). Its earnings are being hurt by some moronic decisions by its financial advisor managers to offer derivative products the company did not understand, costing AmEx a cool billion or so thus far and making the company seem a bit expensive. Keep in mind, though, that AmEx created more than $5 billion in free cash flow in 2000, $5 billion in 1999, and $4 billion in 1998. At its $48 billion market capitalization AmEx is trading at a price-to-free-cash-flow ratio of about 9. For a company of this quality, that is remarkably cheap.

For an explanation of why this is so, think about the services that AmEx offers, its name brand, its consistent history of generating free cash flow, and its strong balance sheet. Will AmEx go up tomorrow? I don't know and I don't care. AmEx, at current price levels, is a good example of the type of company that will end up in the hands of intelligent investors: They understand that it is extremely likely that AmEx will deliver far more than a dollar of retained earnings for each dollar placed at risk over the life of the investment. This investor is willing to weather the storm of worry because his research tells him he has gotten a bargain. Whether or not the market agrees right away is meaningless.

Seven years is a long time, and a recovery may come much sooner. But what if it doesn't? Do you have the confidence in your portfolio holdings that they will not only survive a prolonged slump, but come out stronger on the other side? If you do not, you should sell.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's mother, wife, and sister all celebrate birthdays today, so if you don't hear from him again it means he forgot. At time of publishing, Bill did not own shares in any of the companies mentioned. The Motley Fool is investors writing for investors.