Dancing with the Bear

July 1, 2008

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Dancing with the Bear

Since hitting an all time high of 14279.96 on October 11^th of last year, the Dow Jones Industrial Average (DJIA) will close the second quarter of 2008 officially having entered bear market territory–enduring a 20% decline. The broader market index–the Standard & Poors 500–is off 18.4% from its high on that date, while the Nasdaq Composite–which peaked later in October–has declined 19.4% from its most recent high and the Russell 2000 (small cap) index is off 19% from its high of last summer. I don’t think that anyone would argue at this point that we are not in a bear market. Furthermore, if you look at the peak-to-trough numbers of some of the formerly high-flying equity markets around the world, the recent performance of U.S. equities looks downright docile in comparison. For virtually every major global equity market, the first half of 2008 has been a painful ride.

Most investors would prefer not to experience the pain of a bear market. If investors had the benefit of hindsight, we would all sell our shares at the market peak and get back in once the selling was over. However, investing does not work that way and most research over the years suggests that timing the market is a futile task.

So, with that in mind, what are investors to do when the bear appears? The most important thing to remember is to not panic. While every bear market is painful, it is important to put major market declines into perspective. No market’s chart is a straight line up and to the right. There are peaks and valleys which make the ride more dramatic and stress-inducing than many would prefer. It is part of the game. Historically, the major indices have moved up and to the right in a consistent fashion. However, the ride has not been smooth and there have been significant periods of dramatic under-performance.

The U.S. stock market has been in a funk for over eight years now. Before this difficult period began, domestic equities had enjoyed over 17 years of well-above average performance. Today, we are in effect paying for the sins of this prior “Super Bull” market. By 2000, most major stock averages had valuation metrics (such as price-to-earnings) virtually unheard of based on historic norms. Something had to give—and indeed it has!

While certainly not cheap by historic standards, domestic stocks are much more reasonably valued today than they have been for well over a decade. While the U.S. economy faces unique challenges today that we have not had to confront in the past (a sizeable glut of residential and commercial real estate, historically high energy and commodities prices and a very weak dollar), in many ways, our economy is better positioned to weather this economic storm than it was in the recession of the early 1970s. Back then, manufacturing was a much bigger component of our economy. Today’s economy by comparison is more nimble and able to adapt to the needs of the changing global marketplace.

This is not a time to be overly aggressive in chasing stocks nor is it a time to be using debt to either augment one’s lifestyle or purchase financial assets. However, as the bear market begins to uncover real value in stocks, it is a good time to patiently wait and look for once-in-a-generation opportunities. At Ockham, our methodology uncovers significantly oversold stocks and recommends purchase during significantly oversold general market conditions. While this approach does not guarantee that you will not lose money in a bear market, it does give you the tools to weather the downturn with an eye toward the market’s rebound—which, like the bearish phase, is inevitable.