David French | 18/02/2009 3:55:49 PM

This article was originally published as ‘There’s a bear in there’ in The Morning Bulletin in July 2002. In 2002, the Dow lost approximately 16% of its value.

I have a book that suggests how you can tell whether or not you are in a bear market or a bull market. The bear market list includes corporate and government scandals coming to light, even good news being taken as bad and the market being down more days than it is up. Bear markets are a normal part of our economic cycle, and they serve to correct some of the excesses that accrue during a boom. They are not pleasant – no-one likes to see the value of their assets falling – and they can go on for a long time. Eventually, however they end and asset values will improve.

In almost every case the bear market is brought on by increasing interest rates, and asset prices that do not reflect underlying profitability. Simply, these are the two things that determine asset values. The fact that underlying profitability might not reflect a company’s real profits does not help, and when it’s in a bearish frame of mind the market takes no prisoners when it finds that out.

Here are some important things to think about while you are waiting for the bears to hibernate.

First, have a very good look at your portfolio and toss out any rubbish. Companies that make no profit, pay no dividends and have dodgy management are first in line. Make sure the companies that you invest in have real businesses, preferably doing something that you can see evidence of. If there is evidence of dodginess, then waiting for things to improve will probably end in disaster.

Second, don’t sell good investments. Falling share prices are inevitable in a bear market, but the prices probably have little relation to the underlying value of the investment. If you sell your quality investments one of two things is likely to happen – either you will decide never to invest in the market again, and therefore forfeit any opportunity to recover your losses, or the market will begin to rise the day after you sold!

Third, investments that generate income are very useful when the market is in the doldrums. The income helps buffer falling prices and enables you to purchase additional investments when the time is right.

Fourth, keep some cash aside so you are not forced into a position where you have to sell and so that you can pick up bargains when they arise.

Finally, maintain a portfolio with a spread of assets. Having some property trusts and bonds in your portfolio can help offset falling prices of other assets. If necessary, managed funds may be used to help increase the breadth of your portfolio.

It is impossible to predict when any bear market will end. There will be plenty of experts who say that we are at the bottom, or that we are miles from the bottom. The truth is that you cannot know for certain, however there are some pointers that might indicate when the worst is over. These are:

• Auction clearance rates for residential properties start coming off the boil – if house prices start to fall then the money will begin looking for a new home.
• People expect that interest rates will continue to rise. As we have discussed in other articles, they may not rise by as much as expected. If this view becomes consensus, then asset valuations will rise and the market will stop falling.
• Corporate regulators begin tightening up on the accounting B/S that becomes prevalent during booms, and people again start believing what they are told.

Viewed on a monthly basis from 1961 to 2002, the stock market fell 258 times and increased 240 times, so falls are nothing new. The value of the rises must offset the falls though, because over that same time period, the stockmarket increased by a factor of over 15 times – and that does not include dividends.

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