August 20, 2007

Bear market protectors
Past safe-havens may not repeat

Many advisors and investors are convinced that since their chosen manager(s) or fund(s) sailed through the 2000-2003 bear market smelling like roses, that the same manager(s) and fund(s) should protect them well if the current correction evolves into a full-fledged bear market (i.e. a fall of 20% or more). I hear this reasoning in sales presentations, in discussions with investors and advisors, and in internet discussion forums. But it may be something of a false sense of security.

Bear market drivers

Key to understanding why a particular fund or manager protected (and grew) capital during the last bear market is understanding past bear market drivers. And they're different every time. By the beginning of 2000, technology stocks had been pushed up to extraordinarily high levels, along with other so-called glamour stocks.

Those same tech and glamour stocks were pummelled in subsequent years. The safe-havens following the 2000 peak included financial stocks, commodity stocks, non-tech consumer stocks, income trusts, and non-tech small company stocks. The reason they provided not only shelter from the bear market, but strong returns to boot, is because they were dirt cheap at the tech bubble's peak from having been shunned by investors.

There is nothing magical about small cap or commodity stocks, for instance, that should set the expectation that they'll stage a repeat performance in future bear markets. Seven years ago, they happened to be very cheap - far from the case today. Also, in 2000 it was easy to point to many areas of the market that were in bargain territory. Today, it is much harder to find great bargains, though the recent decline is making it a bit easier.

Tomorrow's saviours

If financials, income trusts, commodity stocks, and small caps won't be the place to hide in the next bear market, what will be? Nobody knows for sure, but I would place my bets on areas that haven't been rising for seven years and represent good value. Look at what's really beaten up and what everybody hates today and you'll get an indication of where you might want to hide. This, in fact, was part of my motivation for my March recommendation to take a close look at bonds after more than four years of rising stock prices. Bonds were far from cheap, but they are usually unloved in the midst of buoyant stock markets.

But sometimes all stocks are being sold off (and falling in price as a result) and, in the short term, cash may be the only safe place to hide. In such an environment, not even great managers will be able to escape the short-term damage. For instance, Trimark Fund SC - a holding in my personal portfolio - delivered a gain of 6% from March 2000 through March 2003, outpacing the index and its peers by some 45 percentage points. Yet, Trimark Fund lost 23% from March 2002 to March 2003 and it lost more than 20% during 1987 (six months ending Nov) and in the decline in the early 1980s.

This isn't cause for worry but it is a reality check. Longer-term investors shouldn't worry, as the above example is of a single fund. Well-constructed diversified portfolios should emerge with relatively less damage than implied by newspaper headlines, escaping permanent impairment by this or future declines (save for a repeat of 1929).

If you're really worried about shorter-term safety, you can simply keep more cash on hand in your portfolio. T-bills and high interest savings accounts boast yields that are not far from that offered on longer-term government bonds. But don't go hog wild shifting to cash. While the market is falling, smart managers - like the folks at Trimark, Cundill, Dynamic, and Front Street - will be opportunistic when attractive investments emerge in the midst of the market panic.

Focus on what matters

It is a portfolio manager's ability to invest with conviction and confidence in extreme markets that separates the great from the ordinary. No single manager can lay claim to being able to protect investors in all market corrections or bear markets. This is just an unrealistic expectation that will lead only to disappointment and ill-timed trading. So, try to unglue your mind from such notions and focus more on the portfolio-building process and the underlying investment policy. If you don't have a proper process in place for designing investment policies and building portfolios, the sub-prime mortgage woes should be the least of your concerns.