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Two big risks

Sorry to be absent here this week. I've been rocked by the flu, and only today started to feel human again. But I'm guessing I'm not the only one feeling a touch of nausea this evening.

The stock market devastation of the past 17 months (particularly since last September) has reached beyond what most people ever imagined. To erase 12 years worth of gains, 56% of the value of the S&P 500, has been staggering. Worse, there's no obvious reason for the slide to stop now.

In every bear market, there are two main risks. Unfortunately, to a large degree, protecting against them is a mutually exclusive situation — you can guard against one or the other, but it's difficult to guard well against both at the same time.

The way most bear markets play out goes like this. The market falls substantially (~30% on average) over a period of 15 months or so, but it rarely does so in a straight line. Instead, the market tends to have several drops of 10-20%, with significant rallies in between. Those rallies keep hope alive as the months pass, until the pain finally becomes too great. Then, in a final selling climax, investors throw in the towel en masse and a bottom is made. Needless to say, this final selling takes place after many months of losses, but before investors have any reason to believe conditions are going to improve.

This is by far the most common bear market scenario and it brings us to our first main risk: selling near bear market bottoms. This is classic investor behavior and is largely responsible for the fact that small investors have earned roughly one-third as much as the market as a whole in recent decades (see Dalbar survey). It's completely natural, completely destructive, and it's how virtually every bear market plays out.

Because this risk is far and away the most common, yet incredibly hard to avoid despite that fact, it's the risk we at SMI have spent almost all of our effort trying to defend against. The 2000-2002 bear market was classic in this sense, and readers who were able to resist the urge to sell near the bottom looked good (at least until the past few months, but realistically even those who sold at the bottom of 2002 were likely back into the market by 2007).

The second risk is probably obvious: there's always a chance that the current bear market is going to develop into something truly devastating. Make no mistake, nearly every bear market appears to carry this potential at the time. Even the market shocks that never develop into full-blown bear markets often look as serious as a heart-attack. Consider these "end of the world" scenarios we've faced just in recent years.

• In 1997, the world faced the "Asian Contagion" which raised fears of a worldwide economic collapse.
• A year later, in 1998, the Russian debt crisis triggered the collapse of Long-Term Capital Management, a situation so serious that the Fed and big investment banks felt they had to bail them out to avoid the whole financial system potentially collapsing (hmm...sounds familiar).
• Throughout 1999, many people stockpiled basic living supplies (and pulled all their money out of the stock market) in anticipation of the Y2K crisis. It's easy to shrug off now, but at the time there were many serious and credible experts floating predictions of utter doom and ruin when the world's computers stopped functioning properly all at once.
• In 2001, 18 months into a nasty bear market and with the economy still teetering on the verge of recession, terrorists struck us here at home. Many experts went on record shortly thereafter predicting that terrorists would strike another U.S. city with some sort of biological or nuclear attack at some point over the next few years. Thankfully that hasn't happened and we pray it never will.

In each of these cases, it was completely reasonable to believe the dire warnings and expectations of doom. Yet none of those scenarios were responsible for the problems the market and economy faces today.

In truth, the really devastating bear markets and economic collapses come along so infrequently that they're extremely hard to prepare for. We had one in the 1930s obviously. Before that, you'd probably have to go back to 1873 to find anything comparable. Before that, 1837.

This is already getting long, so I'll try to wrap it up. Obviously in hindsight, we all wish we'd paid more attention to things like the bear alert indicator that would have allowed us to side-step this carnage. Unfortunately, we can't go back and undo those decisions.

So at this point, with the market down some 56%, 17 months into this bear market, the truly relevant question is this. Is today a replay of the Great Depression, 1873, or 1837? It can't be totally ruled out. And if it's true, there would potentially be some benefit in making defensive moves even at this late date.

But we also have to put today's situation into context. Many people expect some sort of replay of the 1970s as this financial crisis winds down, with lingering economic weakness and robust inflation ahead. If that were the outcome, should we be pulling money out of stocks now? Probably not with them down this far already. The 1970s weren't any fun economically, but if 1973-74 winds up being the parallel, you'd want to be invested with stocks already down 56% from their peak. (The same is true of virtually every other recession or bear market in US history, with the exception of the few mentioned above.)

It's easy to look at the current situation and see the catastrophe outcome. It's more difficult to imagine we're near the tail-end of a severe-but-not-historically-devastating bear market. Again, is today's economy about to develop into one of the worst in the past 200 years, with all that entails? In that context, it's easier to concede there's at least a decent chance that it's not.

So even here at this relatively late date, we're back to the two primary risks of bear markets. Do you protect primarily against being a seller near this potential bear market bottom? Or do you accept that risk and make changes now to protect against "the big one?"

The handful of modest steps we've suggested lately — making small changes to your stock/bond allocation, using SMIVX for some (perhaps more) of your Upgrading money — these are ways to hedge a little against the big one, without being undone by the more common risk that this won't turn into an utter disaster of Great Depression proportions.

We don't know how this will play out. I wish we could tell you, I really do. All we can do is outline the risks as we see them and let you decide what to do with that information. I will say that Austin and I are not selling here. We're not raging bulls here either. We just don't see the risk/reward benefit — at this late date and with the losses we've already absorbed — favoring being a seller here.

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