(Clark Capital) A bear market, which is defined as stocks falling 20% from the prior high, is now upon us. In moments like this, it is completely normal for investors to experience doubt and fear as markets continue to decline. We will never know precisely when the bottom is, which is what makes a bear market difficult for many investors. It’s not the pain itself, but the fact that we do not know when it will stop, which creates the anxiety that can lead to poor investment decisions.
The good news is that with the right approach and guidance, bear markets can present opportunities for investors. Remember, the goal is to help your clients construct portfolios not on the hope that nothing will go wrong, but instead on the expectation that things can and will go wrong in markets.
In this piece, we will explore the three core tenets of how to help your clients navigate a bear market and emerge with a more durable portfolio on the other side. We believe that this is not the time to be passive, but instead to be proactive. As an advisor, it is important to communicate that there is a clear gameplan in place to deal with challenging market cycles. Let’s begin.
Tenet #1: Live to Fight Another Day
It seems simple, but this is not as easy as it sounds. It can be challenging for investors that are already in a distribution phase and are relying on cash flows from their portfolios for income. The risk during a bear market cycle is not that prices are declining, but that an investor may be forced to sell during those declines.
Not only is the investor impacted by selling stocks at distressed prices, but not holding those shares during a subsequent recovery period may further constrict portfolio growth. Amy Arnott at Morningstar highlights this dynamic with the simple chart below in which an investor begins taking a 4% withdrawal beginning in 2000 with an all-equity portfolio.
The Impact of Sequence of Return Risk
| Age | Total Return | Withdrawal Amount | Portfolio Value (End of Year) |
|---|---|---|---|
| 64 | 20.89% | n/a | $1,000,000 |
| 65 | -9.03% | $ -40,000 | $869,700 |
| 66 | -11.85% | $ -40,800 | $725,841 |
| 67 | -21.97% | $ -41,616 | $524,757 |
| 68 | 28.36% | $ -42,448 | $631,130 |
| 69 | 10.74% | $ -43,297 | $655,616 |
| 70 | 4.83% | $ -44,163 | $643,119 |
| 71 | 15.61% | $ -45,046 | $698,464 |
| 72 | 5.48% | $ -45,947 | $690,792 |
| 73 | -36.55% | $ -46,866 | $391,441 |
| 74 | 25.94% | $ -47,804 | $445,177 |
Source: Morningstar. Sequence of Returns: What It Means and How to Deal. For illustrative purposes only. Past performance is not indicative of future results.
This type of outcome could be disastrous for someone with twenty or more years to go in retirement. We believe that having a distribution plan is critical to the long-term success of an investor’s portfolio. By ensuring that enough bonds and cash are in place to provide for many years of income, an investor can give themselves the most valuable asset of all: time.
Tenet #2: Structure Before Anything Else
When an investor puts money into the market, often the first question they ask their advisor is what they should buy. They may also ask: What stocks do I want to own? Do I want to focus on dividends or be more tilted towards growth and appreciation? For bonds, do I go with taxable bonds or tax-free bonds? What kind of credit rating am I comfortable with? Before these questions can be answered, there is an even more important question you may need to discuss with your client: How are you going to buy?
In an environment like the one we are in today, investors may naturally look at others who are panic selling and think that they are wise for investing instead. However, they may in fact be sellers without even knowing it. For clients who only own mutual funds for their investment exposure, this can be the exact situation.
A mutual fund investor does not own the underlying assets, they just own shares in the fund. As other investors in the fund are heading for the exit, they must be given cash for their redeemed shares. The investors that are continuing to hold are punished for that bad behavior. Not only are they being forced to sell the underlying assets at the worst possible moment, but they also absorb the transaction costs (along with any realized gains in non-tax deferred accounts).
Unfortunately, we have seen that 2022 is no different than any other bear market when it comes to poor investor behavior. According to the Investment Company Institute, through June 22nd, outflows from equity mutual funds totaled $156 billion dollars while bond funds have shed $281 billion dollars. An investor holding onto their mutual fund shares may believe that they are a buy and hold investor when in fact they are anything but.
During a bear market cycle, we believe that it is important to help your clients choose the right investment vehicle for their goals and objectives. Mutual funds can be useful in that they allow investors to access a diversified portfolio with a small amount of investable assets. However, for many high net worth investors, owning individual securities in a separately managed account may offer many unique benefits such as customization, flexibility, and the ability to manage taxes.
Tenet #3: Free Cash Flow is King
In recent years, with the outperformance of growth stocks and cryptocurrencies, the term HODL has become a part of the investor lexicon. For the uninitiated, HODL stands for “Hold On For Dear Life.” Particularly in the 18 months that followed the March lows of the pandemic, it seemed that the “HODLers” may have been onto something. Buy a seemingly speculative asset and provided you can stomach the volatility, then you too, dear reader, may have found the key to levels of wealth that seemed unattainable.
Over a long enough time horizon, perhaps that could actually work, but from where we sit today, that certainly seems like a tough way to make a living. In our opinion, rather than HODLing, you should encourage your clients to be compounding to see themselves through the current cycle. A simple question you can have your client consider is: “How much are you being paid to hold these assets?”
Consider the below real-life case study where an investor purchases $500,000 worth of a Healthcare stock on January 3rd, 2000, right before the bottom fell out of the S&P 500 in one of the more memorable bear markets. The interesting thing about this stock? The company pays dividends. Not only do they pay dividends, but they also have a long-term track record of increasing their dividends. Below is an example of what may happen when a shareholder reinvests their growing dividends over five years of owning the stock:
The Power of Compounding
| Dividend Date | Dividend Amount | Approximate Share Purchase Price | Cash Received | Shares Purchased | Total Share Count | |
|---|---|---|---|---|---|---|
| Initial Investment | 1/3/2000 | 46.88 | $500,000.00 | 10,665 | 10,665 | |
| 7-Mar-00 | 0.14 | 35.25 | $1,493.10 | 42 | 10,707 | |
| 13-Jun-00 | 0.16 | 42.38 | $1,713.12 | 40 | 10,747 | |
| 12-Sep-00 | 0.16 | 47.50 | $1,719.59 | 36 | 10,784 | |
| 12-Dec-00 | 0.16 | 47.81 | $1,725.38 | 36 | 10,820 | |
| 13-Mar-01 | 0.16 | 47.48 | $1,731.15 | 36 | 10,856 | |
| 12-Jun-01 | 0.18 | 50.69 | $1,954.11 | 39 | 10,895 | |
| 11-Sep-01 | 0.18 | 55.62 | $1,961.05 | 35 | 10,930 | |
| 11-Dec-01 | 0.18 | 55.52 | $1,967.40 | 35 | 10,965 | |
| 12-Mar-02 | 0.18 | 63.81 | $1,973.78 | 31 | 10,996 | |
| 11-Jun-02 | 0.205 | 59.00 | $2,254.25 | 38 | 11,035 | |
| 10-Sep-02 | 0.205 | 55.20 | $2,262.08 | 41 | 11,076 | |
| 10-Dec-02 | 0.205 | 55.56 | $2,270.49 | 41 | 11,116 | |
| 11-Mar-03 | 0.205 | 54.13 | $2,278.86 | 42 | 11,159 | |
| 10-Jun-03 | 0.24 | 52.72 | $2,678.04 | 51 | 11,209 | |
| 9-Sep-03 | 0.24 | 51.30 | $2,690.23 | 52 | 11,262 | |
| 9-Dec-03 | 0.24 | 49.85 | $2,702.82 | 54 | 11,316 | |
| 9-Mar-04 | 0.24 | 52.67 | $2,715.83 | 52 | 11,368 | |
| 8-Jun-04 | 0.285 | 56.97 | $3,239.74 | 57 | 11,424 | |
| 7-Sep-04 | 0.285 | 57.86 | $3,255.95 | 56 | 11,481 | |
| 7-Dec-04 | 0.285 | 61.83 | $3,271.99 | 53 | 11,534 | |
| 8-Mar-05 | 0.285 | 68.19 | $3,287.07 | 48 | 11,582 | |
| 7-Jun-05 | 0.33 | 66.45 | $3,821.99 | 57 | 11,639 | |
| 13-Sep-05 | 0.33 | 64.05 | $3,840.94 | 60 | 11,699 | |
| 13-Dec-05 | 0.33 | 60.25 | $3,860.73 | 64 | 11,763 | |
| Ending Value | 12/30/2005 | $706,956.30 | 11,763 |
Source: Johnson & Johnson. For illustrative purposes only. Past performance is not indicative of future results.
What we see in the above example is the power of compounding at work. Notice that the stock price over the period when additional purchases were made vacillated anywhere from $35/share to over $68/share. However, by steadily increasing the share count (ownership) of this growing business, not only does the investor increase their shares by over 10%, but their dividend cash flow has increased by over 122% with their portfolio increasing by 41%! This was done all while starting the investment going into the teeth of a nasty bear market. In our opinion, the lesson is to coach your clients to be compounders, not HODLers
As human beings we are hard wired to avoid pain. It is just in our nature. Intellectually, we all know that bear markets are inevitable, yet they always seem to incite the same reactions of panic and uncertainty from the broader public. For those advisors who can help their clients reorient themselves to focusing on these three tenets, bear markets may provide opportunities to come out with a more durable portfolio. Once those concerns are answered, then you can help answer the most important question of all: “How am I prepared for the next bull market?”.
