BY: ANDREW J. WILLMS
PRESIDENT AND CEO, THE MILWAUKEE COMPANY
“Things turn out best for the people who make the best of the way things turn out.” Art Linkletter.
The classic definition of a bear market is a 20% decline from a recent high. By that measure, the technology-laden Nasdaq index and the Russell 2000 small cap benchmark have been in a bear market for some time. Meanwhile, the Dow Jones Industrial Average and S&P 500 index have been able to avoid crossing that threshold, but have traded considerably lower in their own right.
More generically, a bear market refers to a sharp decline in prices, where selling begets more selling. Thought of that way, it seems clear that a new bear market has begun.
While news outlets often cast bear markets in a very bad light, in truth they usually are not as dreadful as the press makes them out to be. To the contrary, bear markets are an inherent part of a free-market economy, and are needed to shake out excesses that can build up in markets as a result of what former Fed Chairman Alan Greenspan referred to in a 1996 speech as irrational exuberance.
In fact, bear markets can be seen as opportunistic events that periodically arise in the normal course of market volatility. Here are some ideas to consider when the bear growls.
- Buy Low. A bear market can be thought of as a sale on stocks. Moreover, the lower valuations that result from a market sell-off makes investing in stocks less risky than they were when prices were higher. That said, before you invest be sure you are ready to stay the course if prices fall further. While most everyone likes a bargain, further markdowns are a definite possibility.
- Use Dollar-Cost Averaging. If you have some cash to put to work in the market, consider doing so in equal, scheduled, installments. When markets are volatile, dollar cost averaging lessens the risk associated with the timing of your investment.
- Diversify Your Portfolio. It can be emotionally challenging to reposition your portfolio if it results in the recognition of large amounts of built-in capital gains, even if doing so means higher expected future returns. A bear market allows you to reposition your portfolio with a lower tax bite.
- Harvest Capital Losses. A bear market may also afford you the opportunity to realize built-in capital losses for tax purposes, which in most cases can be used to offset future capital gains indefinitely. And, if you sell an ETF to harvest losses, chances are very good that you can reinvest the sale proceeds in an ETF that is very similar to the one you sold, without having to wait the 30 days required when trading individual stocks.
- Convert to a Roth. As I have discussed previously, Roth IRAs and 401ks have a tremendous tax advantage over traditional IRAs in that distributions from Roths are entirely tax free. But this advantage comes at a cost: You have to report the entire amount being rolled from a traditional retirement account into a Roth in income in the year of a roll-over. If a bear market lowers the dollar value of your traditional retirement account, the tax triggered by the conversion can be a great deal less.
- Revisit Your Estate Plan. As I discussed in last week’s newsletter, your investment plan and your estate plan should work together to facilitate the accomplishment of your objectives. A bear market can create estate planning opportunities by lowering gift taxes on lifetime transfers, and facilitating the use of a variety of estate planning techniques that can lessen the death taxes your heirs have to pay. (Maureen O’Leary and I discussed this topic during this week’s Market Commentator podcast, which you can listen to HERE.
- Reassess your investment objectives. If a bear market causes you to deviate from your investment plan, or keeps you up at night, you are probably overly invested in riskier assets and should restructure your portfolio. Capitalize on this realization by revisiting your investment objectives and risk tolerance after things calm down a bit, and then develop a systematic process to implement whatever changes may be in order.
- Invest in ETFs. If the stock of an individual company craters during a bear market, it may never return to its previous glory. By comparison, broad market index-tracking ETFs have a stellar track record of recovering their bear market losses and heading higher, given enough time.
- Maintain a positive attitude. Bear markets can be hard to endure (which is why stocks earn higher returns than bonds). The good news for U.S.-oriented long-term investors - every recession and bear market of the past was ultimately followed by an economic expansion and a new all-time high in the future.
While the above may not make you feel good about the arrival of a bear market, hopefully the foregoing observations will help you remain a bit more sanguine about it. As the old saying goes, when life gives you lemons, make lemonade.
Please let me know if you would like help with implementing any of the foregoing suggestions. I would be glad to be of assistance.