All we really need to know we learned in kindergarten, including the story of Goldilocks and the Three Bears. 2021 was Goldilocks and 2022 was Baby Bear, so 2023 will be Mama Bear and 2024 will be Papa Bear. If you can remember this, then you will invest far better than most grownups.
2022 was a classic first year of a bear market with familiar themes from similar past bear markets.
Bear markets are much more similar to each other than bull markets. We experienced a large-cap growth stock bubble one year ago which was very similar to the bubbles of September 1929, January 1973, and March 2020. Just as in those three previous periods from the past century, the large-cap growth shares which caused the bubble in the first place mostly dropped in 2022 about twice as much as the average U.S. stock during the past year, just as they had done in 2000. We also had three sharp bounces along the way, including the current one which began around the beginning of the fourth quarter of 2022. It is therefore logical to assume that 2023 will be similar to a year like 2001, with generally steeper losses during each downtrend, along with stronger bounces in between downtrends and probably with a moderately larger total loss for 2023 compared with 2022.
Throughout 2022, the U.S. dollar, emerging market securities, and highly speculative assets (think cryptocurrencies) also behaved as they generally do during the first year of major bear markets.
VIX and TLT varied from the usual script throughout 2022.
Two interesting differences from analogous past bear markets included: 1) the failure of VIX to reach 40 throughout 2022; and 2) the dramatic weakness of U.S. Treasuries and their funds, including TLT, which dropped about twice as much as they usually would during the first downward phase of a bear market. Since we had more net inflows into the U.S. stock market in 2021 than during 2001 through 2020 combined (not a misprint), presumably these tardy buyers included many less-experienced investors who are not familiar with bear markets.
I expect U.S. Treasuries and VIX to surge sharply higher during the first half of 2023, partly to compensate for their overdone 2022 weaknesses.
In a bear market, you can make money selling short on the way down while purchasing U.S. Treasuries and gold/silver mining shares along with other deeply oversold securities near each intermediate-term bottom.
Selling short the most overpriced U.S. large-cap equity funds will likely continue to be a winning approach, which you can enhance by periodically selling covered puts against these whenever VIX is beginning another retreat. This can be enhanced by adding to the most undervalued long positions whenever there is the least insider selling and the greatest outflows by the least-experienced investors. U.S. Treasuries and gold/silver mining shares in particular tend to enjoy net gains even with sharp corrections during these kinds of bear markets; look at a chart of VUSTX (long-term Treasuries) or HUI (gold/silver mining shares) from 2000 through 2003. I have therefore been adding to both of these sectors during their most depressed periods of 2022.
Closed-end funds often provide outsized bargains during intermediate- and long-term bear market bottoming patterns.
Some investors aren’t as familiar with closed-end funds as they are with open-end or exchange-traded funds. Especially during bear markets, closed-end funds are often sold by those who are disappointed or discouraged or who are otherwise emotionally unhappy about holding anything which has dropped for two years or longer. This causes many closed-end funds to sell at higher discounts to net asset value than they experience during bull markets.
In February 2009, near the end of the severe 2007-2009 bear market, I went to Cefa.com and ranked all closed-end funds from highest discount to lowest. By the middle of the ninth page, the discount finally dropped below 20%. When I did the same test in January 2010, less than a year later but when fear of losing more money had been replaced by fear of missing out on additional gains, the discount dropped below 20% halfway down the very first page. This means that the number of closed-end funds with high discounts was 17 times as high in February 2009 as it was in January 2010.
It is especially likely that the next market bottom following a “Mama Bear” retreat, perhaps around the middle of 2023, could be accompanied by very high discounts for some worthwhile closed-end funds. Select those where the fund manager(s) have their own money in the fund, where they have been managing the fund for several years or longer, which have relatively low expense ratios, and which rely on value investing principles rather than using leverage or other financial tricks to enhance their performance.
Value investing is once again taking over from growth as these major groups take turns outperforming through the decades.
The following chart highlights the see-saw behavior of value vs. growth investing since 1975:
I expect value shares to lose much less than growth shares on the way down for a couple of years, just as value had lost much less overall in 2022, and to gain substantially more on the way up for five or six years during the next major bull market (2025 through 2030, approximately).
Differentiation is clearly underway
In my last update, I forecast that investors would begin to differentiate among sectors, so that not all shares would go up or down by similar percentages. This has been increasingly prevalent in recent months, as gold mining and silver mining shares and some emerging markets have been far outgaining large-cap U.S. growth favorites from 2020-2021. Part of the critical shift from growth to value will be the increasing outperformance of small-caps versus large-caps, emerging markets versus U.S. securities, mining shares versus technology, and in general, the big winners of 2000-2008 trouncing the big winners from 2009-2021.
It is okay to be a Boglehead with assets which may have completed their cycle bottoms, including government bonds and gold/silver mining shares. It’s not okay to be a Boglehead with SPY, QQQ, or any collection of previous large-cap U.S. growth favorites.
Why did U.S. large-cap growth stocks perform so well in 2021? It wasn’t because their profits increased faster than the profits of other sectors. The primary reason by far is that we had the biggest ever inflow of inexperienced investors in 2021, who in many cases had never invested in anything before. Being unfamiliar with the financial markets, they invested in names they knew from their everyday lives regardless of how overpriced they had become, and therefore created unsustainable bubbles. Just as a hangover must result from having far too much alcohol, 2022-2024 is the inevitable morning-after resolution of 2021. All of those big-name U.S. technology shares have to go back to fair value and probably well below, since bear markets usually end with an average 30-50% discount to fair value for these shares.
Dollar-cost averaging is not a worthwhile approach for any overpriced asset class. You might lose less on the way down, but it will still represent a huge overall loss.
I am gradually adding to my short positions and reducing my long positions during the upcoming month to restore their balance from the middle of August 2022
At the end of September and the beginning of October 2022, I sold covered puts and added significantly to all of my long positions in order to create a much heavier weighting of longs versus shorts compared with their mid-August interrelationship. Now that VIX has retreated almost all the way to 20, I plan to use the next few weeks, especially shortly after the opening bell into all upward spikes, to progressively reduce my long positions except for U.S. Treasuries and gold/silver mining shares and to add to my short positions in XLI, XLE, SMH, QQQ, and XLK. You can’t make as big a percentage gain by selling short as you can by being long, but in a bear market, the most consistent gains will almost always be on the short side.
XLI and XLE are new short positions, with SMH possibly joining them soon
I began to sell short XLE when it had first reached 93 a couple of weeks ago, and I have been more recently selling short XLI at 101 and above. Both of these sectors are among those which have more than doubled from their respective March 2020 bottoms, have experienced intense selling of their components by top corporate executives, have enjoyed massive net inflows in recent weeks, and frequently climb shortly after the opening bell most days – which is when the least-experienced investors do a large percentage of their total trading. SMH has experienced a sharp bounce in recent weeks, so I may begin selling it short soon. If QQQ approaches 300, and especially if it surpasses that level, it is also worth adding to my already existing position.
I’ll take the over on the duration of this bear market
Many investors believe that either the current U.S. equity bear market has ended or that it will terminate within a year or so. In my opinion, that’s not likely, and I’ll happily take the “over” on that bet. The earliest the current bear market could end, based upon the experience with all past lengthy bull markets (the bull market ending in January 2022 had begun in March 2009), would be in the summer of 2024, and that is probably too early by some unknown number of months.
I’m sure that by the time the current bear market has ended, I’ll be losing plenty of money on the long side from having gotten invested far too soon and too high.
Old-fashioned savers can get their best deals from U.S. government bonds, especially U.S. Treasuries of 26 weeks, 52 weeks, 2 years, and 3 years until maturity
Most investors are unaware that U.S. Treasuries have been sporting their highest yields since the summer of 2007. You can get over 4.7% on some securities and over 4% even on the shortest 4-week Treasuries. A good place to do this is TreasuryDirect.gov, which charges no fees and allows you to participate in the same auctions as multi-billion-dollar institutions.
The bottom line: 2023 will resemble 2022 but with larger percentage pullbacks, bigger rebounds, and outperformance by U.S. Treasuries and gold/silver mining shares
As we transition from the first to the second year of a three-year U.S. equity bear market, we are likely to have a similar transition as we had experienced in 2000 to 2001. Mama Bear will rip apart large-cap U.S. growth shares, but will be considerably gentler to safe haven assets, including U.S. Treasuries along with gold mining and silver mining shares; Baby Bear in his inexperience treated almost all assets the same (i.e., not with care). In addition to selling short, put lots of money into 26-week, 52-week, 2-year, and 3-year U.S. Treasuries, which have enjoyed their highest yields since the summer of 2007.
Disclosure of current holdings:
Here is my current asset allocation as of the close on Wednesday, November 23, 2022:
XLK short (all shorts currently unhedged): 18.84%;
QQQ short: 6.71%;
XLE short: 4.90%;
XLI short: 0.64% (November 25 close);
TSLA short: 0.35%;
GDXJ long: 10.40%;
ASA long: 5.93%;
GDX long: 2.74%
BGEIX long: 1.34%;
I Bonds long: 8.95%;
TLT long: 8.78%;
2-Year/3-Year/52-Week/26-Week/13-Week/5-Year TIPS long: 7.76%;
Gold/silver/platinum coins: 5.54%;
INTC long: 2.34%;
TKC long: 2.33%;
GEO long: 1.87%;
TEI long: 1.42%;
KWEB long: 1.32%;
FXY long: 0.85%;
FXB long: 0.18%;
FXF long: 0.17%;
VZ long: 0.65%;
EPOL long: 0.34%;
T long: 0.22%;
WBD long: 0.20%;
HBI long: 0.11%;
LEMB long: 0.06%;
PCY long: 0.05%;
NGL.PB long: 0.02%;
CEE long: 0.02%.
The numbers add up to more than 100% because short positions only require about 30% to hold them with no margin required.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.