Advanced Tactics for the Next Bear Market
Bear Market or Not? What To Do
“Panic is not an investment strategy,” says Liz Ann Sonders, Chief Investment Strategies with Charles Schwab & Co., Inc.
When the market drops precipitously, many people are gripped with fear or, at least, concern. How do you know whether the drop will be a typical correction (5% – 10%) or the beginning of a severe bear market (20% or worse)?
The Frequency and Severity of Market Declines
According to data compiled by J.P. Morgan1, since 1926 (92 years of history) there have only been ten bear markets, including the two in this century. Here is the list:
|Bear Market||Market Peak||Bear Return||Duration*|
|Crash of 1929||Sep. 1929||-86%||33|
|1937 Fed Tightening||Mar. 1937||-60%||63|
|Post WW II Crash||May 1946||-30%||37|
|Cuban Missile Crisis||Dec. 1961||-28%||7|
|Civil Unrest – late 60s||Nov. 1968||-36%||18|
|OPEC and Stagflation||Jan. 1973||-48%||21|
|High Interest Rates||Nov. 1980||-27%||21|
|1987 Crash||Aug. 1987||-34%||3|
|Tech Bubble||Mar. 2000||-49%||31|
|Great Recession||Oct. 2007||-57%||11|
Several observations can be made:
- Declines of 20% or more are infrequent—only 10 in 92 years.
- While extremely painful, they are not permanent. That is, they do not last very long. The longest duration was five years, and the average is just over two years. The crash of 1987 lasted only three months, and the Cuban Missile Crisis decline was only seven months.
- They did not occur in every decade; there were none in the 1950s or the 1990s.
- They do not always happen in September or October, as many people seem to think.
What causes these large drops?
J.P. Morgan goes on to show that there are four primary reasons for bear markets: 1) a recession is almost always associated with a bear market—eight out of the 10; 2) a spike in commodity prices (such as OPEC in the 1970s); 3) the Federal Reserve (Fed) being overly aggressive in raising interest rates was responsible for four of the nine, including just prior to the global financial crisis of 2007; 4) extreme valuations (high stock prices relative to earnings; i.e., high P/E ratios) have been responsible for half of them, and high P/Es accounted for the only two bear markets which were not associated with a recession (including the Tech bubble of 2000-2002).
Corrections—market declines of at least 10% but less than 20%–are much more common. Over the past 90 years they occur, on average, about once a year, and the typical recovery time is just eight months.
Also, in many, many of the calendar years in which a decline of 10% or more occurred, the stock market experienced a positive return for the year. In fact, from 1980 through 2017 (38 calendar years), there were 21 years that had a 10% or greater decline. Of those 21, the market finished the year in positive territory 14 times (including 1987 and 2009); only seven were negative years.
Drops of between 5% and 10% are much more frequent, occurring about once a quarter. But the recovery time is also short, usually two to three months. These 5%-10% drops are unpredictable and unavoidable. We believe investors in equities should simply accept the fact that they will occur with annoying regularity, and not go to extraordinary lengths to try to avoid them.
Currently, in the fourth quarter of 2018, stocks are not over-valued. Their P/E ratios are very close to their long-term (25-year) average. Also, economic fundamentals are strong, and most metrics do not indicate an imminent recession. While the Fed is raising rates, most experts agree it is not “overly aggressive” in doing so. The yield curve is flattening, but it has not inverted. And GDP growth is strong and increasing. Remember, the classic definition of a recession is two consecutive quarters of negative GDP.
Therefore, we believe it is highly unlikely that market volatility in late 2018 will lead to a bear market decline of 20% or more. But, during a correction, there are some planning moves a person can make.
So, what should a prudent investor do?
10 Tactics to Employ During Market Declines
There are several intelligent moves to make when—not if—the stock market enters correction territory (>10% decline). Some are more advanced than others and do not apply universally to all investors. Competent legal, tax, and financial advice should be consulted prior to utilizing any of these tactics.
1. Create and fund a GRAT (Grantor Retained Annuity Trust)
A GRAT is an advanced estate planning tool for people with a taxable gross estate, especially for those who live in a state with a state estate tax and a low exemption amount. Without going into great detail, an investor funds a GRAT with stock or stock mutual funds and gets paid back from the GRAT the entire amount, plus interest.
The interest rate is based on the published Internal Revenue Code (I.R.C.) §7520 rate, currently about 1.4%. If the appreciation on the asset donated to the GRAT exceeds 1.4%, then all of the excess appreciation goes to the heirs. Better yet, there is no taxable gift and the excess appreciation is not subject to estate taxes.
A recent New York Times article stated that Fred and Mary Trump (Donald’s parents) put apartment buildings into GRATs back in 1995 and successfully avoided millions of dollars of taxes. The controversy as to whether this was legitimate tax avoidance was not aimed at the GRAT strategy itself, but at the valuation of the apartments the Trumps claimed.
The GRAT term can be two years, five years, 10 years or more. At the end of the term, the amount left in the GRAT goes to the heirs designated in the document.
Thus, when the market declines and stock prices are temporarily low, it presents a tremendous opportunity to benefit from the eventual recovery.
2. Transfer assets to an Irrevocable Trust
Another estate planning technique is to transfer a house, stocks, or other appreciating assets into an irrevocable trust. There is no estate tax advantage for the transfer itself, but again, the benefit is that when prices rise after the transfer, all that appreciation value is outside of the estate of the person making the transfer.
Estate planning professionals call this an “estate freeze,” as the value of the asset being transferred is frozen as of the date of the transfer. All subsequent growth is not part of the taxable estate.
3. Liquidate a Deferred Annuity and reposition into a tax-efficient account
Most fiduciary advisors do not recommend clients invest in variable deferred annuities. This is because internal fees are very high, significant surrender charges (early withdrawal penalties) are a problem, and growth in value—while tax-deferred—eventually is taxed as ordinary income instead of the more favorable capital gains rates. Also, annuities do not enjoy stepped up basis after death as capital assets (real estate, stocks, mutual funds, etc.) do. This means that the heirs must pay income taxes after the annuity is transferred to them.
When someone realizes that investing in an annuity was a mistake, the problem is then how to get out of it. There is often a 10% free withdrawal amount each year that is not subject to surrender charges, so a slow liquidation (which also spreads out the tax hit) is recommended.
But once the surrender charge period is over, selling the entire annuity could create a large tax liability. Thus, a market decline presents an opportunity to liquidate while prices are down and the taxable gain is lower. It is a good time to sell out of the annuity and reinvest in lower cost, more tax-efficient investment vehicles that enjoy both lower capital gains rates during lifetime and stepped up basis after death.
4. Execute a Roth Conversion
A Roth Conversion from a Traditional IRA is a taxable event. Generally, it makes sense if the person will be in a higher tax bracket later in life, when withdrawals would be tax-free. In other words, pay taxes now at a lower rate and withdraw later tax-free in a higher tax rate environment.
The new 2018 tax law requires a careful estimate of the tax impact of a Roth conversion. And for those on Medicare, be aware that the higher AGI (adjusted gross income) resulting from a Roth conversion could cause a senior to pay higher Medicare Part B premiums.
If it makes sense to do a Roth Conversion (and it does not make sense for everyone), the best time to do it is when the stock market has tumbled. Because a Roth IRA is totally tax-free for both growth and withdrawals, it is wise to put the most aggressive (highest growth potential) investments of an overall allocation into the Roth. When the market goes back up, these more aggressive investments should appreciate even greater than the general stock market.
5. Realize capital gains on legacy positions and reinvest into an evidence-based/scientific asset allocation
- Get out of high expense mutual funds. Not all mutual funds are created equal. Much has been written over the past 10 years or more regarding the high internal fees of many mutual funds. This issue has been a primary focus in the Department of Labor ruling on the necessity of a financial advisor being a fiduciary when working with retirement accounts. If a high expense mutual fund has been held for many years, selling it could create a large capital gain. While its performance may be lagging due to the high fees, a person may be reluctant to sell and realize those gains. A market pullback presents the opportunity to sell at a lower tax hit and reinvest in a more cost-effective mutual fund within an evidence-based asset allocation strategy.
- Reduce or eliminate single stock risk. No one thought General Motors would go bankrupt (or Lehman Brothers, or WorldCom, or Enron, or Texaco.) But they did. Owning individual stocks presents a tremendous level of risk. This risk can easily be diversified away. But, selling a stock that has been held for many, many years can create a very large capital gain and a big tax hit. It is prudent to eliminate single stock risk and diversify into a sensible, scientific asset allocation.
An investor should be very careful in designing a liquidation strategy, and this could be accomplished over several years. A bear market is an opportune time to accelerate that strategy and reinvest the proceeds into more diversified investments at a time when prices are down.
6. Leverage gifting to family members utilizing annual gift exclusion (including 529 plans)
Most people are aware they can gift up to $15,000 per person per year; this is known as the annual gift exclusion. This amount also functions as the upper threshold for funding 529 plans for the future college education of children or grandchildren.
What better time to gift or buy stocks and stock mutual funds than during a stock market correction or bear market? If an investment has dropped in value from, say, $18,000 to $15,000, it could be gifted at that time. When the market recovers, the person has leveraged the gift—effectively gifting an investment worth more than the temporary lower value at the time of the market drop. Funding a 529 plan at a market low accomplishes the same thing—buying when prices are low so that the value after the market rebound is greater than the amount of the gift.
7. Take RMDs (Required Minimum Distributions) from bonds in IRAs and invest after-tax proceeds in stocks (if over age 70-1/2 and not needed for living expenses)
Retirees who must withdraw a certain amount from their IRAs each year can either spend that money or reinvest in an after-tax account. If the plan is to reinvest, it makes sense to take the RMD when stock prices are depressed and immediately re-invest in stocks at low prices. The person can effectively remove more shares at lower prices from the IRA, pay the requisite taxes, and then invest for the eventual recovery in value.
Basic Tactics (but difficult for individual investors)
8. Harvest losses
Any time the market sells off, it is a good time to examine each holding within the portfolio. If any of the positions have an unrealized loss, that position should be sold in order to realize the loss for tax purposes. Then, the proceeds are immediately re-invested in a similar, but not identical, asset. Fiduciary investment advisors do this as a normal part of their investment monitoring process.
However, individual investors find this emotionally difficult to do. In fact, many investors don’t want to sell when an investment is up because they’ll have to pay capital gains taxes. And they don’t want to sell when it is down because it might mean they made a mistake, and they’d rather wait for it to back up to prove themselves correct. This is flawed thinking.
A scientific asset allocation has specific target percentages for different types of stock, bond, and alternative investments. There should be a primary and secondary fund for each asset and sub-asset class in the portfolio. The fiduciary advisor simply sells the primary fund which is at a temporary unrealized loss and on the same day purchases the secondary fund in the same asset class. This harvests the loss for tax purposes, but maintains the asset allocation. The losses can then be used to offset up to $3,000 of current income as well as current/future capital gains.
9. Rebalance portfolios
Again, this is easy for professionals and difficult for individual investors. And again, this is due to individual investors’ emotions and behavioral psychology. Simply put, within the asset allocation of stocks, bonds, and alternatives, when one category has dropped in value versus its target and other categories have risen in value, sell the “winner” and buy the “loser.” That is emotionally counter-intuitive because most investors want to hang on to their winners and get rid of their losers (or, as stated above, wait for them to come back).
Rebalancing forces a mechanical way to sell high and buy low. Most people know that is the way to make money, but it is not easy to actually do it. Rebalancing has been shown to both reduce risk and help improve returns over time.
Vanguard, the mutual fund company, calculated that the value of rebalancing by professional advisors added about 35 basis points annually (+0.35%) to the average client’s investing experience.2
10. Buy! Invest excess cash. And, if eligible, contribute to a Traditional or Roth IRA.
“Keep some dry powder” is one of those ancient Wall Street adages. It means to always have some cash on the sidelines, and when an opportunity presents itself, an investor has the cash to capitalize on that opportunity.
“Buy low and sell high” is another well-known phrase. When the bear market or correction occurs, it is the proper time to invest and buy stocks.
It is also a good time to consider contributing to and investing in an IRA, whether deductible or not. There are AGI limitations, as most people are aware, but if eligible, it makes good sense to contribute to an IRA during a market decline and invest for the long term.
All ten of the strategies above have similar themes. These include the estate freeze, the leveraged gift, or the concept of selling bad investments and buying good investments at low prices. In addition, tax considerations are an important part of the plan.
If market declines were permanent, none of this would be good advice. However, since throughout history stock markets around the world have shown tremendous resilience and a persistent upward trajectory, it is a valid assumption to believe that good businesses will do whatever it takes to optimize profits. Stock prices and company profits are related (the “price-earnings” or “P/E” ratio). Thus, as profits improve, stock prices also move up.
Sources:  “Bear markets and subsequent bull runs”, Guide to the Markets, March 2016, J.P. Morgan Asset Management.  “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, March 2014, The Vanguard Group, Inc.