How to Prepare for the Coming Bear Market

More than five-and-a-half years into a bull market that has produced a 226.9% total return in Standard & Poor’s 500-stock index, it’s time to prepare for the next bear market.

The Five Best Stock Funds to Own Now

I don’t know when the gut-wrenching market plunge will occur. No one does. But I do know that stocks are no longer cheap. The S&P 500 trades at 18 times earnings for the past 12 months, compared with the long-term average of about 15.5 times earnings. It’s a good time to go over your portfolio with an eye toward how it will withstand the next bear market.

But first: What should you expect in the next bear market? Let’s look at history. The past is hardly a perfect guide to the future, but it’s the best we have. In spite of stunning global developments and technological advances, human behavior remains little changed. The same strain of mass euphoria that infected investors in the late 1990s was widespread in the late 1920s. Likewise, the same variety of pessimism that haunted us in the 1930s was prevalent after 2008, albeit to a lesser degree because the economy wasn’t nearly as decimated.

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The good news is that the next bear market probably won’t be nearly as awful as either of the last two bear markets. That’s because the last two bear markets were the worst since the Great Depression. In the 2000-02 bear, the S&P tumbled 47.4%. The index took until late 2006 to recover—only to endure a 55.3% collapse from 2007-09. And we didn’t break even after that massacre until April 2012. (Ned Davis Research supplied the data on bear markets, which are defined as 20%-plus declines in the S&P 500 including reinvested dividends without intervening rallies of at least 30%.)

The last time a bear market hit investors so hard, Franklin D. Roosevelt was president. Stocks plummeted 51.5% in the 1937-38 bear market. That implosion was the worst since 1926, except for the Great Crash of 1929-32, when stocks utterly collapsed during a rapid series of back-to-back-to-back bear markets. Large-company stocks fell 44.4% in two months in late 1929, regained much of that loss in the ensuing months, and then sank again. By the time the ups (and mostly downs) were complete, the market had lost an unimaginable 83.5%. And that catastrophic loss, as well as the other return statistics in this article, includes dividends. A hapless soul who invested his money on Sept. 6, 1929, didn’t break even until December 1944, as the allies were advancing on Germany toward the end of World War II.

A typical bear market, by comparison, looks almost tame—but only by comparison. On average, bear markets have cost investors 36.9%. Since 1926, we’ve suffered through 19 bear markets, or one nearly every five years. On average, stocks have fallen for 11 months before hitting bottom.

Suppose you have the worst timing possible and dump all your money into stocks just as the market peaks ahead of a bear market. On average, it has taken such an investor three-and-a-half years to break even. But the cumulative return five years from the peak has averaged 25.1%—not great but not horrible, either.

Some bear markets barely cause a pinprick. I remember well the S&P 500’s staggering 20.5% crash on Oct. 19, 1987. I feared we’d fall into a depression, or at least a recession. Instead, the crash marked the end of a two-month bear market, the shortest on record, according to Ned Davis, and the economy barely missed a beat. The S&P sputtered and took almost two years to break even, but then it went on to post a parade of new highs in the following decade.

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In the post-World War II period, only one bear market caused real devastation. That was the 1973-74 shellacking, which you could argue was in some ways worse than the 2000-02 bear due to its breadth and economic backdrop. During the eventful bear market of the 1970s, the S&P plunged 45% amid long lines for gasoline, Richard Nixon’s resignation and the onset of severe inflation.

Some experts afterward labeled that drop a “generational bear market”—the notion being that every generation had to be scared to death just once to learn to invest a bit more rationally. Yet that rationale overlooked the fact that an earlier generation suffered through not one but a series of bear markets that spanned three decades (1929-42). In recent years, we have experienced the 2000-02 tech meltdown and the 2007-09 bloodbath—either of which could be labeled as this generation’s big bad bear market.

Take Steps to Bear-Proof Your Portfolio

The lesson is clear: No one knows when a bear market will occur, how awful it might be or what will cause it. High price-earnings ratios are often a signal of how deep a bear market might be, but not always. Notably, the 2007-09 bear was so bad because of a financial crisis; valuations weren’t all that inflated.

How should you prepare for the next bear market now? In my view, you should put most of your money in large blue-chip companies with low debt levels and healthy profit margins. Don’t overlook European and Japanese multinationals. I recently recommended five good stock funds that invest in domestic and foreign companies with such qualities.

Emerging markets and small companies will almost surely be hammered worse than blue chips in the next bear market. Hold on to them only if you think you can endure short-term pain.

Finally, look in the mirror. If you’re heavily invested in stocks and can’t stomach the thought of saying goodbye (on paper, at least) to more than one-third of your money—the amount lost in the average bear market—sell some shares. It’s so much better to sell early than to wait until the bear market bares its claws.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.