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Responding to bear market conditions

We talked about the continuing global bear market in equities on Monday, but there was an important corollary to this discussion that was not addressed (we will address it here now). The question is this: how do you, as a trader or investor, respond to bear market conditions?

To spur your thinking on this subject, I will present two very different views on how investors might respond to the same bear market conditions. In the following passages, Bennet Sedacca of Minyanville, and Kent Thune of The Financial Philosopher, share their thoughts on planning for and investing through the bear market portion of market cycles.

As you read this, think about which of these perspectives works best for you. Do you try to identify and capture the various trend and counter trend moves, adopt long/short investment portfolio and trading strategies, time the market (through charting and historical data referencing) and attempt to avoid bear phases altogether, or continue to invest with a well-thought out plan that encompasses defensive investments and asset allocation strategies?

Remember: each person needs to find a trading or investment strategy/plan that suits their own unique temperament, skill level, outlook, and goals. We all see things differently, and variations in individual judgement, response, preferences, and psychology are some of the key things that make markets function!

In, "The Sun Will Come Out in 2010", Bennet Sedacca looks to past presidential/fiscal stimulus cycles as a guide for identifying future rally stages in the context of an ongoing secular bear market.

Though bad news is currently in abundance, and a bear market is evident, Bennet feels that some knowledgeable, active investors can plan ahead to take advantage of opportunities that will present themselves in the coming months and years.

"The economy and the credit/equity markets are anything but a walk in the park these days. But hey, this isn't a game for amateurs, and this cycle will most certainly show us who a) understands the big picture, b) knows how to measure risk and c) knows how to preserve capital.

Why? Because the sun will come out tomorrow. Tomorrow may be a bit far off, but it's out there. The goal now is to make it there with your capital intact, and even with some gains along the way.

The difference between realists and “perma-bears” is this: “Perma-bears” wake up praying for rain and don’t like to plan for tomorrow. Realists, on the other hand, look to get through the rainy days, and then pounce when the sun's about to peek out again."

According to Bennet, many investors have been lulled into a false sense of security by the previous secular bull market (1982-2000) in shares, and an overwhelming focus on long-only investing programs. This outlook has not served individual investors well since the secular bear market in US stocks began back in 2000.

"Folks are starting to figure out that traditional long-only investing means that you have to be invested for a long time. I have no problem with that philosophy, provided your time horizon is 100 years and you don’t mind 15- to 17-year periods where you don’t make any money (like the one we're in now).

Frankly, I have yet to meet an investor with a 100-year time horizon and the patience to sit through a secular bear market in stocks - and the volatility that goes with it."

What is the flip side of this "buy and hold/pray" mantra? Bennet outlines his view in part 2, by emphasizing the need to stay cautious and capture the counter trend moves.

"I believe the correct posture is one of caution, not to be confused with being bearish. I believe that every bet one makes must be measured and have considerable thought behind it.

It's truly okay to miss opportunities but the big cyclical moves, even within secular bear markets, must be had. The same is true for cyclical bear moves within secular bull markets, which I believe could be a result of a combination of both time and price...

...I do believe one thing for sure. The sun will definitely come out tomorrow. I just have to be around with my capital and my investor’s capital to take advantage of the sunshine."

Meanwhile, Kent Thune at The Financial Philosopher feels differently about trying to anticipate market direction and movements.

In his opinion, the best strategy for most investors is a patient and disciplined approach to investing. Kent expresses this view in, "The Wisdom of Asset Allocation":

"I believe time in the market, with proper asset allocation, is preferable to "timing the market," which is a fool's game. In my view, time in the market refers to investing early, investing often, and staying in for the long-term. Albert Einstein called compounding interest "the most powerful force in the universe" and it represents "time in the market" at its best.

Here's a classic example: Which would you rather have -- $1million today or one penny doubled every day for one month? If you chose the penny doubled then you are the "winner" with $5,368,709.12. Time exponentially expands the compounding effect. With less time to invest, even the most skilled traders will find themselves at an enormous disadvantage to compounding interest..."

So as Kent points out, and as The Rolling Stones sang, when it comes to saving and investing, "Time is on my side".

But what does the average investor do in the face of an oncoming (or ongoing) bear market? Shouldn't he sidestep such an event and lighten up on his share holdings until the storm has passed?

Kent addresses this point in, "Invest Like a Philosopher: Intro to Asset Allocation":

"Unless you are a professional market timer (which, if you think about it, is an oxymoron) you should be using stocks for their most logical purpose (long-term investing) and your investment portfolio should be allocated in such a way that allows you to respond similarly when someone comments on the market news of the day: "Who cares?"

Simply stated, one can not logically begin the asset allocation process by constructing a portfolio based upon unknown variables; therefore, we must begin the process of asset allocation by separating the known from the unknown.

The investor's (1) Investment Objective, (2) Investment Time Horizon, (3) Amount of Money available to Invest, and (4) Risk Tolerance/Capacity are, in my opinion, the only known variables while everything else, such as future market performance, is largely unknown.

Asset allocation is about creating and maintaining a portfolio of assets (stocks, bonds, cash) that is based upon those four known variables so the investor's concern over the unknown variables are significantly reduced or even removed. Furthermore, proper asset allocation effectively reduces volatility, which, in turn, reduces the human temptation to buy or sell into short-term market movements."

Whether you hew more closely to Kent's view of prudent investment guidelines, or Bennet's call for anticipating and trading/capturing the trend and counter trend moves, one thing is paramount for investors and traders. That is the ability to know yourself, to know your own tolerance for risk, your strengths and weaknesses, and what works well for you. The more I learn about successful traders and investors, the more this theme stands out.

Have you encountered useful advice or lessons in formulating strategies for investing or trading in bear markets?

Maybe you've come across a helpful book, or have uncovered some useful guidelines for surviving and prospering in these down markets.

Share your thoughts, experiences, and investment and trading wisdom here with us!

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