7 Things You Should Do Before the Coming Bear Market

No, it’s not that kind of article. I don’t know when the bear market is coming, and neither do you.

No, it’s not that kind of article. I don’t know when the bear market is coming, and neither do you.

I could recite a whole litany of indicators from stock valuations to credit spreads to margin debt levels showing you that we are a lot closer to extreme greed in the markets than any other reading. However, that won’t tell you when things will reverse.

Yet, the bear market is coming, sooner or later. And when it does, you will want to be ready.

I have invested professionally through two bear markets over the last 25 years. The first one was the 2001-2002 Dot Com bubble crash during my early days when I was a young analyst at Fidelity. The second one was during the 2008-2009 Great Financial Crisis when I was a portfolio manager at a different firm. There have been numerous other, smaller, market declines as well along the way.

Chances are you haven’t invested professionally through one, much less through two real bear markets. Many investors started buying stocks in the last 15 years, which but for a few very brief interruptions have been mostly one long bull market.

Since human psychology, which cycles between extreme greed and extreme fear, hasn’t changed much over a few decades, you want to be prepared before the bear market kicks into full gear. So here are seven things you absolutely need to do to be ready.

1. Write Down Your Investment Process

It’s going to be hard to be disciplined if you aren’t 100% clear on what being disciplined means. You might think that you know, but trust me, in the chaos of a tumultuous market you will want to have your process written down.

Then, when you are tempted to act, or afraid to, you can refer to your written investment process and follow your own wisdom from a calmer time to the letter.

What’s more, you will want to share it with others who will be affected, be it your spouse, your clients or your board. That’s exactly what I have done when I started my partnership and shared Silver Ring Value Partners’ Owner’s Manual with all the partners so that we are clear on the ground rules. It’s a great way to both manage expectations and hold yourself accountable.

2. Don’t Focus on Short-Term Returns

Lately, I have been encountering a lot of “investing bros” online eager to boast about their short-term returns. It has even become popular for some to put their YTD returns as their LinkedIn tagline.

Let me assure you that few of these folks so eager to brag now will be regularly updating you when their YTD returns are -37% as opposed to +53%. It’s just human nature.

Regardless, the important thing for you is to shift your focus away from short-term, near-random, outcomes to the process. Grade yourself on one thing: how well are you sticking to your written down investment process. Ignore the rest.

3. Only Hold Investments You Don’t Mind Seeing Drop 50%

Some stocks are path dependent. That means that a company might be fine if the troubles are short, mild or both, but if we are in for a long, deep cycle you might get wiped out or at least seriously impaired.

Don’t do it.

You can only calmly ignore market turbulence if you’re confident short-term price swings don’t reflect long-term fundamentals. Sitting there and biting your nails while guessing if the market will recover before your investment goes bust is not going to be fun or conducive to good decision making.

4. Build a Wishlist of Quality Companies to Buy at the Right Price

Quality companies are a small minority of all companies out there, but there are still many to choose from. The problem is that right now almost all of these are quite richly priced.

That leaves little margin of safety to be wrong and meaningful downside if these turn out to be just decent rather than great businesses.

Rather than convincing yourself a rich valuation is justified, be patient. Study the companies and establish a price at which they are a no-brainer buy. Then wait. Believe me, most of the time when you hear people tell you “But company X is so amazing it will never trade at Y price” they will be wrong.

5. Watch Out for Double Leverage: Financial + Operating

Operating leverage means that a small decline in sales leads to a large decline in profits due to a meaningful fixed cost percentage. So, think a 10% sales decline leading to a 30%+ decline in profits. The highest operating leverage results from a combination of high fixed costs and low margins.

Financial leverage is more nuanced. Of course, you can demand no debt and call it good. Some investors do that, but I think that unnecessarily excludes many investable companies.

The question is how much room a company’s balance sheet has relative to bank covenants or cash funding needs when it will be forced to raise capital. Raising capital during a bear market will at best be extremely expensive and at worst result in total loss.

If you are not sure about a specific balance sheet, just pass. You don’t want to go into the bear market with a bunch of levered companies.

6. Don’t Be Afraid to Hold Cash

“Time in the market > timing the market.” Yes, yes, we all heard this fortune-cookie wisdom. The key is understanding when it applies. If you are holding broad market indices and plan on only investing through them, then the above is right. Just dollar cost averaging is likely your best approach.

However, if you are investing in a portfolio of individual securities, forcing yourself to be fully invested prevents you from being an absolute value investor. Instead, you are going to end up picking the best of a not-so-good opportunity set even if the likely returns at those prices will be subpar.

So no, I am not suggesting you time the market. What I do is let cash be a residual of my bottom up investing process. I will not target any specific cash level no matter how expensive the overall market, but I will also not talk myself into buying mediocre investments either.

The math of waiting is very forgiving. Permanent capital loss is not.

7. Don’t Buy Too Early (but Do Buy)

Benjamin Graham famously bought into the stock market crash that started in 1929 too early and lost a lot of money. Conversely, there is a strong “deer in the headlights” feeling that you are likely to get when stocks keep going down day after day. The trick is balance.

That’s where your written investment process, company wish list and starting portfolio of safe investments all come in. If you have set yourself up for success you now need to force yourself to pull the trigger, but only when your process tells you that you should.

Conclusion

Even if you do all these things, the bear market will not be easy. It will test you and make you appreciate Peter Lynch’s quote that the test of an investor is in his stomach, not his brain.

However, being disciplined and prepared is your best chance to weather the coming storm. If you act wisely, you might even benefit from the chaos around you while many other investors are panicking.

What’s on your bear market preparation checklist? Please leave a comment below, I read and respond to every one. And if this article helped clarify your thinking, please restack it to help others.

Disclaimer: Not financial advice, for educational purposes only.

About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.