Articles

Richard Maitland Sarasin

The bear market of 2000-2003 came as a shock to most investors; over the previous 20 years, equities had produced returns of nearly 20% per annum, with just two mild down years in 1990 and 1994. While the autumn of 1987 contained a crash, so much money had been made before October, and the rebound was so rapid, that 1987 as a whole was positive. It is not surprising that so many investors were mostly unprepared for the 40% fall caused by the doubly whammy of the dotcom crash and the second lurch down following the terrorist events of 9/11.  

When the 2007-2009 financial crisis took hold just five years later, most investors fared better, albeit they were equally surprised and fearful at the time. The previous bear market was a recent memory, lessons had been learned, and on this occasion, the rebound was ‘V’ shaped: fast and paper losses were recouped quite swiftly.

As a reminder, a proper bear market requires the vast majority of investors to be truly surprised and shocked by the cause, pace and extent of any decline just as we witnessed earlier this year. The COVID-19 collapse is thus no different and follows the pattern of a classic stockmarket collapse. 

This article focusses briefly on how best to weather these storms, firstly by taking action before a crisis strikes, secondly how to act during the criris, and finally what actions to consider once markets appear to have stabilised.

Actions required prior to the next inevitable bear market

In terms of strategy, what follows is a summary of the ‘Planning for Bear Markets’ chapter in our Compendium of Investment. It is not written in reaction to the latest market turmoil, but in response to all the bear markets that preceded it. It forms the foundations of our strategic work and is a hallmark of our approach to successful long-term investment.

Education: everyone should be aware that bear markets occur and that they will surprise virtually every investor. They will have a significant impact on long-term portfolios biased towards equities and other return-seaking assets: the down ‘leg’ might well see a return of -20% to -40%. Recovery from the low point might be a matter of months, but it might also take several years. Income may well suffer, but is typically less volatile than capital. Liquidity will dry up in some asset classes.

Cash flow, asset and liability matching: on the basis that equities will produce significant volatility, they should only be used for those with appropriate timeframes: those who can sit on the sidelines and wait, with no need to access their capital for at least five years. For those with less time to spare, equities should only make up a small part of their assets. If one expects to spend capital within 12-18 months, equities and their ilk are probably not suitable at all.

Asset diversification: it is easy by the end of a bull market to allow a portfolio to become less well diversified, selling assets that might protect you in a downturn because they appear to offer scant short-term reward. It is common to see gilt and cash levels reduced to levels at which they offer little overall portfolio protection.

Security diversification: it is not just important to diversify across asset classes: are your equities geographically well-diversified? From a sector position, are you over-exposed to some of the higher yielding sectors like banks or oil companies?

Activity during a crisis

Typically, the best damage limitation is carried out prior to a crisis and the best mitigation, afterwards. However, there are some instances where even the best plans have to change and there are things that can and should be considered as events unfold.

Cash flows and projections: the fallout from bear markets is varied and will impact companies, people and institutions differently, as will the way in which governments and regulators react. Only as matters unfold will you be able to consider the ways you and your organisation will be impacted and the extent to which your preventative actions have worked. As you analyse the situation at hand, you might need to realign your assets and/or your resources to real world issues.

Dialogue and discussion: it is highly unlikely that your investment portfolio ‘will go to zero’. In extremis, individual companies might go bust and some specific bonds might default. There will be weeks when it feels as if the whole portfolio is doomed, but bear markets and recessions do end. They can cause lasting and permanent damage to certain sectors, but the world finds a way through each crisis. This COVID-19 bear market and economic shock might result in a longer and deeper recession than we have seen for many years, but our central expectation is that economies and markets will recover. Ultimately, talking through your worst fears with a proactive, calm and experienced investment manager and reminding oneself of past collapses and recoveries in confidence should ensure that emotions are kept in check.

Active management: investment managers will need to review their portfolios; have their strategies and tactics held up as they expected? Were they positioned well, but for the wrong reasons? Do the new circumstances mean changes are required? How will each equity perform from here; could any corporate bonds default? Should one buy the dips and switch defensive stocks into those that might recover faster or should we reduce risk if a second leg down looks likely?

The aftermath

Some of the most lasting and damaging impacts from a bear market are caused by actions taken after the event.

Changing horses mid race: some managers are prone to do well in bear markets, other in bull markets. Some try to outperform a little in each. Knowing your manager’s natural style bias is critical and too many investors only discover what they have bought after the event. In 2003 and in 2009, after savage bear markets, many investors moved their affairs to target return, absolute return and ‘glass-half-empty’ managers, only to underperform in the next bull phase. Some completed the circle by reappointing glass-half-full managers in 2007 and 2019! Better to switch out of defensive managers after a bear market and optimistic managers after a bull market than to do the reverse and lock in periods of poor performance. Or pick a more balanced manager who doesn’t err towards the more heroic end of the investment spectrum! 

Strategy: there will always be stories of those who bailed out of markets just before the disaster struck and managed to buy back at the bottom. Even broken clocks show the correct time twice a day. However, one of our defining philosophies is that investors should never rely entirely on skill to avoid losses. We have always felt that a robust strategy lies at the heart of long-term success. This article therefore ends where it started: the best defence against the next bear market is not to withdraw from investment markets completely, or to try and double up at the bottom, but to put in place an asset mix – quite possibly split between different portfolios with different objectives - that matches your requirements and which ensures you will never have to be a forced seller at the bottom of a bear market. 

What’s different this time?

At the time of writing, we are staring down the barrel of a global recession. This is likely to result in almost unprecedented dividend cuts. This is a particulary harsh burden for charities, many of whom rely heavily on their investment income streams to uphold their mission. We hope our clients are relatively well-positioned, given our global and thematic approach to equity selection and the breadth of asset classes and investment techniques we use. However, we will not avoid dividend cuts. We will work tirelessly over the months ahead to produce attractive capital and income returns going forward, but everyone should brace themselves for lower income receipts.