How to Invest for the Coming Bear Market

As the correction intensifies, it’s time to start planning ways to cash in on the growing abundance of bargains.

We may not be in an official bear market yet—but it sure feels like one. The Dow Jones industrial average plunged by nearly 540 points during the day on January 20, before finishing the trading session off by 249 points, or 1.6%. Standard & Poor’s 500-stock index logged a decline of 1.2%. Nearly 1,300 stocks that trade on the New York Stock Exchange hit new 52-week lows.

The S&P 500, down 13% from its May high, is deep in correction territory—defined as a decline of at least 10%. To be considered a bear market, share prices need to fall at least 20% from a previous high. The typical S&P stock is already there; on average, stocks in the index have sunk more than 25% from their respective 12-month highs. The Russell 2000, a barometer of small-company-stock performance, crossed into bear market territory earlier in January, and is now 23% below its June peak.

Carnage in the oil patch is historic. As oil prices have collapsed, earnings in the energy sector have fallen 65% since their peak—twice what companies in the S&P 500 suffer during a typical recession, say analysts at Bank of America Merrill Lynch. Likewise, prices of energy stocks have fallen more than the market falls in a typical recession: 44% versus 40%.

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The Bear Case. There’s good reason for the bear case. The collapse in commodity prices reflects worries about a lack of demand stemming from a steep slowdown in China, the world’s second-largest economy. Its economy grew at the slowest pace in 25 years in 2015, triggering worries of a global recession that will ultimately threaten U.S. growth. The strong dollar is taking a bite out of profits for U.S. multinational companies. It doesn’t help that investors are also worried about the course of Federal Reserve interest rate hikes and jittery about geopolitical strife at several of the world’s trouble spots.

But a U.S. recession “made in China” would be unprecedented, says economist and market strategist Ed Yardeni, of Yardeni Research. And although plunging oil prices hurt the energy industry, they are an overall plus, says David Kelly, chief global strategist at JP Morgan Funds. “The biggest impact of cheap oil is that it represents a tax cut for global consumers—hardly a threat to the global economy,” he says. Kiplinger’s expects the U.S. economy to be good but not great in 2016, with gross domestic product expanding by 2.5%.

Even if the economy avoids slipping into recession, investors won’t necessarily escape a bear market. The good news is that bear markets that aren’t associated with recessions tend to be short and shallow. The S&P 500 declined by an average of roughly 30% during recession-free bear markets in 1961, 1966 and 1987, according to BofA Merrill Lynch, compared with about 40% for bear markets that coincided with recessions. However, the more-severe a bear market, the more likely consumers are to pull back, increasing the odds of recession.

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Doug Ramsey, chief investment officer of the Leuthold Group, in Minneapolis, is in the camp that believes the bear has already attacked. He sees its tracks in the massive losses in economy-sensitive stocks, especially transportation and small-company shares. Eventually—and sooner rather than later—the blue chip Dow and S&P indexes will follow suit, he says. “We’ve been in a bear market for about eight months,” he adds. “We could be two-thirds of the way through in terms of time, and maybe halfway through in terms of price on the S&P 500.” Ultimately, Ramsey sees the S&P 500 declining 25%, taking the index to about 1,600 over the course of the next two to four months. We think that sounds about right, given our relatively upbeat take on the economy.

What to do now. Of course, no one knows for sure what the market will do today, next month or over the course of the year. And no one rings a bell at market peaks or troughs, so unless you get very lucky, trying to time the bottom of this selloff will be an exercise in futility.

How you should react to the downturn depends primarily on your time horizon and on your tolerance for losses. Certainly, times like these call for a gut check. If you can’t sleep at night, or don’t have time to recover from losses of bear market proportions—after all, they’re to be expected in the normal course of investing—then use any bounces to lighten your holdings. And before you cut back dramatically, consider the alternatives for your money: At less than 2%, the yield on 10-year Treasury bonds is currently less than the average dividend yield of the S&P 500, and the average money market mutual fund yields 0.07%.

Investors with a longer-term horizon should be thinking about boosting their stock holdings. The fact is, stocks rise over the long haul. In 10 years, BofA expects the S&P to be in the neighborhood of 3,500, nearly double today’s level. And it’s the price at which you buy in relation to corporate earnings and other measures that determines 60% to 90% of your returns, according to a BofA analysis. Stocks in the S&P are selling at less than 15 times expected 2016 earnings, compared with more than 17 times back in March 2015, and bargains are emerging by the hour.

There’s no rush to buy; prices will likely fall from here. It’s a good idea to formulate a re-entry plan, such as dollar-cost averaging with a bear market twist: Invest in the market periodically, but use decline thresholds instead of time intervals to determine when. For example, put more money into stocks every time the market falls, say, another 5% from the current level. If you invest in individual companies, start to assemble a shopping list of stocks to buy at what you deem to be an appropriate price.

For now, the best place to ride out the present selloff is with high-quality companies, those with strong balance sheets and earnings you can depend on. For fund investors, Vanguard Dividend Growth (symbol VDIGX), a member of the Kiplinger 25, delivers steady returns with below-average volatility by focusing on companies with low debt, high profitability and a history of consistently raising dividends. PowerShares S&P 500 Low Volatility Portfolio (SPLV, $36.19) is a good choice for investors who prefer exchange-traded funds; year-to-date, the fund has lost 6.0%, compared with a decline of 9.0% for the S&P 500. High-yielding utility stocks are a classic defensive play. Utilities Select SPDR ETF (XLU, $43.07) is a low-cost ETF with a loss of only 0.5% so far this year.

High-quality stocks to watch include Nike, (NKE, $59.04), a company that dominates the global athletic wear market, and J.M. Smucker (SJM, $119.38), a consumer staples powerhouse. (Share prices and returns are through January 20.)

Ultimately, you’ll want to steel yourself to buy some of the real stinkers of the bear market—because they’re likely to lead the way out of it. “Values are being created in small caps, energy and materials stocks,” says Ramsey. When they start to outperform relative to such defensive groups such as healthcare and utilities, you’re near the end of the overall market decline. He adds that foreign stocks, including especially hard-hit emerging markets, will be worth a look later on.

Anne Kates Smith
Executive Editor, Kiplinger's Personal Finance

Anne Kates Smith brings Wall Street to Main Street, with decades of experience covering investments and personal finance for real people trying to navigate fast-changing markets, preserve financial security or plan for the future. She oversees the magazine's investing coverage,  authors Kiplinger’s biannual stock-market outlooks and writes the "Your Mind and Your Money" column, a take on behavioral finance and how investors can get out of their own way. Smith began her journalism career as a writer and columnist for USA Today. Prior to joining Kiplinger, she was a senior editor at U.S. News & World Report and a contributing columnist for TheStreet. Smith is a graduate of St. John's College in Annapolis, Md., the third-oldest college in America.