The Next Bear Market

There's no official definition of a bear market, but most analysts reserve the designation for a 20% decline from a recent peak in a major index. Some nitpickers also set a minimum time period before granting the "bear" label. For The Vanguard Group the slump must last at least two months. The masochist at Wikipedia needs a full 12 months of torture before calling a bear. As for me, I'm a chicken. An intraday decline of 20% would have me hallucinating about the furry beast.

Glass half-empty
Since 1950, there have been eight declines greater than 20% in the S&P 500. I'm pulling rank on Wikipedia and calling all of them bear markets, even though three of those declines took less than 12 months and, thus, wouldn't meet Wikipedia's fussy standards. For example, the legendary crash of 1987 was part of a dramatic 33.5% decline in the S&P 500. But it lasted only three months from peak to trough. Similarly, the 20%-plus declines that began in 1962 and 1966 lasted only seven and eight months, respectively.

But I am strictly enforcing the 20% rule. Thus my list omits two near bears: the 19.4% decline over 18 months in 1976, and the 19.9% decline over a thankfully brief 13 weeks in 1990. Without further ado, then, here are the beastly stats:

Glass half-empty: S&P 500 bear cycles

At their worst, the S&P 500 declines since 1950 have twice shrunk the market value of the index by nearly half. The grueling 21-month bear market that began in 1973 cut the index by more than 48% before the beginning of next bull market. And many of us have vivid recollections of the savage decline that began in March 2000 with the popping of the Internet bubble. The S&P 500 finally bottomed out 31 months later and 49% lower. Over this same period, the Nasdaq fared much worse. Its all-time closing high of 5048.62 shriveled to a low of 1114.11, a 78% decline in 31 months.

Glass half-full
Fortunately, bear markets are only half of the cycle, and a much smaller half at that. The chart below shows the nine bull market advances since 1950 from a bear bottom (no pun intended) to the next pre-bear peak:

Glass half-full: S&P 500 bull cycles

The bull phases average over four times the length of the bear phases. And the average gain of 165.7% is a hefty reward for enduring the 33.2% average decline during the bear campaigns.

Problem: Is the glass half-full or half-empty?
The most recent S&P 500 high of 1,565.15 on Oct. 9 came exactly five years to the day after the expiration of the last bear market. The recent housing slump, turmoil in the credit markets, decline in the dollar, and probable slowdown in consumer spending suggest the possibility that a correction is underway.

Is this the beginning of the next bear, or merely another bull market buying opportunity? Only time will tell. Meanwhile, there is something you can do to keep the bear at bay.

Solution: Don't settle for one glass
Remember the definition: A bear market is a decline of 20% from a recent peak in a major index. The S&P 500 is indeed a major index and a standard reference for market cycles.

But this index represents a single asset class -- large-cap stocks domiciled in the United States. And therein lies the clue for solving the glass half-full/half-empty conundrum. Get a variety of glasses. You may prefer a matched set when entertaining guests, but for investing, a diversified set makes for a better party.

Since its high in March 9, 2000, the S&P 500 lost and recovered 49% of its value, and it currently sits below the 2000 high. Meanwhile, investors who diversified into other asset classes have enjoyed superior returns. Other asset classes would include international stocks, real estate investment trusts (REITs), and commodities such as energy and precious metals. Also, overweighting value stocks within the overall class of large-cap U.S. stocks can be an effective strategy. Dividend-paying value stocks tend to outperform the broader index when the bear growls.

Bonds and bond funds constitute another asset class that usually holds up well in bear markets. These come in a variety of flavors, both domestic and international. Representative funds would include Vanguard High Yield-Corporate Bond Fund (VWEHX) and T. Rowe Price International Bond Fund (RPIBX).

Need some help?
Asset allocation is regular focus at the Motley Fool Rule Your Retirement service. To put you on the right track for portfolio diversification, take the next 30 days to check out the service for free. The feature article in the December newsletter, "Expanding Your Assets," offers excellent advice on diversifying your investments across multiple asset classes. Whether you're 30 years from retirement or already there, if you're looking for the thoughtful strategy to survive the bear and ride the bull, click here.

Fool contributor Doug Short (TMFDoug) is available to answer questions on the Rule Your Retirement discussion boards. He own shares of Diageo, which is a Motley Fool Income Investor recommendation. Vanguard High Yield-Corporate Bond Fund is a Champion Funds pick. The Motley Fool has an ironclad disclosure policy.