Strategies for a Secular bear Market – Part 3

In this four part discussion on paradigm shift, you should have picked up by now that it is my considered view that we are not going through a paradigm shift in financial markets that is structural and hence permanent in nature.

A more accurate term might be ‘cycle.’ The cycle will turn again and we need to get prepared for when it does but in the meanwhile not overreact to the extent that we take our eye off the ball and miss the beginning of the next cycle or even miss taking opportunities during this cycle due to excessive fear.

When will this cycle end and the next one start? Readers can research cycles in the past in their own time:

• Technically, research cycles in index price movement and all market PE Ratio movement.
• Fundamentally, research the business cycle in the short, medium and long term and the associated inter-market variables that affect the business cycle such as bonds, commodities and equities.

My view is that there are simply many more variables at play than these. My view is also that we do not need to know when this cycle will end and the next one start if we deploy strategies that can work relatively well in all market conditions. Sure, we need to adapt our expectations accordingly, as it is difficult to extract returns that are simply not on offer without a huge amount of knowledge and effort while still continue doing the things that we do in our lives on a daily basis.

Before getting into suggested strategies, let’s look at how investors have reacted so far during this cycle. There has been:

1. A flight into cash from equities and equity managed funds, mainly by retail investors that have felt pain (financial and emotional) in equity markets to some degree. Effectively cash is a ‘spectator’ investment strategy, i.e. sit on the sidelines and do nothing.
2. An emphasis on seeking yield from large cap defensive stocks. In principle I agree with this strategy. See below for more comments.
3. Demand for access to bond markets by retail investors with plenty of media coverage by business and political notables. As a result there have been some new Bond ETFs issues in 2012 in Australia by iShares.
4. Massive growth in establishing SMSF’s (Self Managed Super Funds) meaning large redemptions from managed and industry super funds. This is affecting the Super industry in Australia as participants move to take control of their own investment funds, the majority of which will probably sit in cash.
5. A huge growth in apathy for investing by retail investors.

I have chosen to restrict my comments only to reactions in the financial world and exclude the general population and political reactions during this deleveraging cycle. I have also not included any discussion on property, residential or commercial.

All of the above are contrarian indicators as investors become more and more drained by a tough investing environment that proves to be more and more difficult from which to derive a half-decent return.

Is flight to cash a long term solution? I would suggest not, as cash returns simply will not provide sufficient returns for retirement, but nearly all investors are aware of this. Refer to my 4 part blog on investing for retirement that started on 3 May: http://blog.sharewealthsystems.com/?p=1916

The amounts of capital that have moved into cash and fixed interest investments suggest mild panic, as record cash investment levels are reached through increased saving but more through cash as an investment. As more and more capital is moved into cash, despite investors knowing that it is a poor long term investing solution, it becomes a bigger and bigger contrarian indicator as the herd moves beyond the mean, driven mainly by fear.

No investing skills are learnt by becoming a spectator and sitting in cash unless there is a timing element to doing so and a specific strategy to move out of cash upon an objective set of criteria being met to move back in other asset classes.

Historically bonds haven’t been an asset class that retail investors have used directly but are becoming more and more the flavour of the times. Beware, bonds have bull and bear markets too. Typically bonds are invested in for yield returns but they have become more of a capital growth play as yields have continued to fall and bond prices have continued to rise. Eventually the tide will turn and bond prices will fall as yields rise. A timing element will therefore be necessary at some stage to avoid large capital losses in this asset class.

The concern is that investors that have become spectators – because there is a new paradigm and the “secular bear will never end” – will miss nearly all the run-up that will eventually take us out of the secular bear market, and then, to make things even worse, will join in with the herd near the top of that bull run and lose again on the way down. As usual, the herd will move at the wrong end of the market when expectations will be that the “bull market will never end.”

The bottom line is that investors need to take some risk but not in all market conditions all the time.

“A world economy dominated by deleveraging is a very different animal than a world economy dominated by an accumulation of debts.
As investors, you have to position your portfolios accordingly and–I want to be firm on this point–you have to adopt a tactical approach to investing. Take advantage of rallies when you see them, but be prepared to take profits. In a period of deleveraging, you win by not losing.” Charles Sizemore.

This means that some degree of timing is required, especially to exit positions to protect against any major down moves that might occur.

A key point that I would like to make before getting into the strategies is that equities will start rising strongly well BEFORE the deleveraging process ends. History has shown this time and time again. Investors should prime themselves for this and start learning and deploying strategies now, not then when it will be too late.

Strategies suggested NOT to use in a secular bear market which are low effort, medium knowledge, low skill strategies:

1. Buy and hold a general equities portfolio.
   
2. Buy and hold equities managed funds.
   

Suggested strategies for a secular bear market will be next week’s topic.