O.K. Let’s catch our breath after January’s devastating results. The question is, are we, or are we not in a bear market? And the answer is yes. And no. Yes, Tech stocks and small cap stocks retraced 20% from their October highs, and that is the definition of a bear market. But the broader based Dow and S&P averages did not reach the 20% level.

There was no shelter from this storm, unless you count the gold funds and the bear market funds, so this is as good a chance as any to discuss bear market investing.

The best introduction to the concept of gold investments as well as the very long term trend in the market is Jeremy Siegel’s iconic investment classic “Stocks for the Long Run“. There is nothing more re-assuring than to look at his chart tracking the growth in equities from 1802 to the present.

During these two centuries, the long term compound rate of return for stocks is between 6.6 and 7.0%, after inflation. Fixed income over the same time period has been barely able to keep up with inflation, and Gold has actually lagged inflation over the same time period despite its reputation as an inflation hedge.

Predictably, the media has gotten it all horribly wrong. The Houston Chronicle Business section is chock full of articles about “where to put your money in a bear market”, and the debate is narrowed to government savings bonds and insured certificates of deposit. This is why the individual investor always buys high and sells low. They panic in unsettled times, instead of scooping up the bargains.

The same family that will fight to be first in the parking lot at 5 AM to buy bargains on the black Friday after Thanksgiving, will pass up equities that have just been marked down by 20% in a major clearance sale (i.e. the January market).

What you need to do is to closely examine the chart tracking the progress of stocks, bonds, notes, gold and inflation that Siegel has tracked for the past 200 years and pick out the trend. One dollar invested in stocks in 1802, and constantly reinvested would be worth $8.8 million by the end of 2001. One dollar invested in gold would be worth $14.38 at the end of 2001.

And all the terrible calamities that have fallen on our country….the Civil War, all the World Wars, the recurring panics and bear markets, the great depression….the entire catalog of catastrophes….when plotted against the span of 200 years, it all looks like so many minor squiggles on the path towards overwhelming progress. You need to have this chart firmly implanted in your memory if you want to be a successful long term investor.

That brings up the topic of bear market funds. You can now take a short position on almost any asset class with the recent introduction of the inverse mutual funds and exchange traded funds that mimic trend reversals on all major asset classes. And if you are especially confident in your judgment, though the use of derivatives, you can double down on your bet. There are now funds that will mimic 200% of these inverse indicia. Does this make sense? Well, yes, maybe, if you are a hedge fund, and you will get 20% of the profits if you are right, and none of the losses if you are wrong. (How did the rich ever end up on the short end of this sucker bet?) Hedge funds allow the managers to bet the farm on the other guy’s nickel. It it works they are rich, and if it fails, well, it wasn’t their money to begin with. Back to the drawing board.

Theoretically, there is a place in modern portfolio theory for non-correlating assets such as bear market and gold funds. But you have to get it right on the timing going in and getting out, or you will get spanked, maybe in both directions. But whatever happens in the short run, long run there is reversion to the mean which brings us back to Siegel’s 200 year chart.

So this is my recommendation. Short the panic, not the market, and go long the reversion, which is persistent and inevitable if 200 years of history means anything at all. This is “back testing” on steroids. In other words, if you were fully invested in your desired percentage of equities going into the downturn, now is the time to add to equities to bring you back to that percentage.

Maybe you can look at Siegel’s 200 year chart and see opportunities in bailing out or shorting the market during the downturns. Hey….It’s good for the brokerage firms. Remember, they get their ticket punched whether its a sell or buy order. Me….I’m in this for the long haul. Two steps forward and one step backward. Not necessarily in that order. Halting progress, but progress nonetheless.

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Posted: 02|5|08 at 6:10 am. Filed under: mutual funds, personal finance, stock market.
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