• Financial & Investment Management Group
  • Tuesday, January 06, 2009

Making Money During Bear Markets

by Barry Hyman
Posted October 14, 2008
FIM Group
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Bear markets don't feel good, especially to those who don't have faith in economics, cycles and people. The lack of such confidence makes it hard to stay the course. A natural temptation after watching the market or the value of one's portfolio decline is to think about "getting out," moving to cash or hitting the "panic sell" button. Everyone knows you are supposed to "buy low and sell high," yet most people invariably do the opposite. Letting emotions drive investment decisions causes people to "sell low" more often than not. Trust and confidence are essential to avoid falling prey to emotions.

The majority of the public invests in assets when doing so is in vogue. Somehow it feels right to many people to invest after astute investors have already made the easy money and then get out while or after prices have "corrected." Invariably, when the dust settles we hear and read that some investors made a fortune by buying foreclosures during a real estate bust or buying struggling companies or industries at a fraction of their value during a recession or bear market.

For most of us it is very difficult to fight the emotions (fear during a decline, greed during a run-up) and instead have conviction in sound thinking. For others it is second nature to understand the fear and exploit the opportunities created by others' emotions. Why is it easy for some investors to see the logic of buying when others are gripped with fear? I believe it is a matter of faith. For some, like the portfolio managers at FIM Group, that faith comes from a combination of experience and understanding along with knowledge of many previous cycles.

Have They Lost It?

"I think they've lost it," one client said about us recently. In reading the online newsletters of several investment management icons, it is the same thing many highly regarded managers are being accused of these days. The current environment is reminiscent of prior difficult market environments. During market cycles of the past two decades, FIM Group has been fortunate not to have suffered near the magnitude of the declines that many managers suffered, partly because we are smaller, more nimble and more flexible. But, to the casual observer, we in fact look like we've "lost our minds," "missed the boat" or are "not paying attention" to what is going on.

Questions such as, "You're buying preferred stocks in banks and financial companies? Don't you guys read the papers or watch the news?" are quite common during periods like this, just as the questions of why we were buying beaten down "old economy" companies during the tech bubble or unwanted Asian stocks during the Asian Economic Crisis were common questions then. We are value and opportunistic managers. The best bargains are created when everyone is panic selling. It just appears foolish at the time and thus takes courage to buy them! Let's look at an analogous situation from the late 1980s.

The Savings and Loan Crisis

The S&L crisis was pretty much concurrent with the junk bond crisis; just as the current banking and credit crises are concurrent. In the S&L crisis, the FDIC identified about 1,500 "problem banks" with serious deficiencies that threatened their continued viability (by contrast, the FDIC has identified only 90 such banks this time around, out of approximately 8,500 total banks in U.S.).

During the S&L crisis, investors panicked and sold off bank stocks, and in doing so created a great opportunity for long-term investors. Granted, something like 1,000 banks were shut down or taken over, but there was no way the government and the regulators were going to allow the financial system to collapse. Investors who seized the opportunity and had the courage to invest in a diversified portfolio of financial stocks reaped significant returns.

Figure 3

Click to Enlarge

The figure below shows that from their peak in September 1989 (the black line at month 36), bank stock investments, as measured by the Morningstar Financial Category, dropped approximately 35% during the S&L crisis to their trough levels in October 1990. Investors who held onto their financials did just fine in the years ahead as sentiment recovered. Those savvy enough to average down their cost by buying more financials as fear dominated the market did even better (even if they didn't perfectly "time" the bottom).

The green line overlays the same Morningstar Financial Category leading into the current financial crisis. As of June 2008, this category is also down approximately 35% from its May 2007 peak as investors have once again panicked. Expecting an exact repeat of the recovery made during the S&L crisis is probably not warranted. That said, the current environment of financial sector fear, combined with distressed valuation levels, does have our team optimistic that contrarian action today will benefit our portfolios over the long-term.

One of my favorite adages of value investing is, "You make the most money from bear markets – it just doesn't feel like it at the time." We are confident this is such a time.

 
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