FSO Editorials: Bear Market Investing for the Long Term

Bear Market Investing For the Long Term - #2
Profiting From Gold's Volatility
by Robert B. Gordon, Sc. D.
October 10, 2003

In this essay, we’re going to cover some further aspects of rebalancing a diversified portfolio holding 10 different asset classes in four main groups. But first let’s discuss some recent market developments.

In his recent October 3 issue of the Elliott Wave Theorist, Robert Prechter has given his latest status summary for the precious metals and stock markets. Based on the very recent events in both of these markets, his conclusions are that both are in the process of ending bear market rallies and resuming their downtrends. In the case of gold, it means resuming a downtrend that started at the 1980 price peak of about $800. Prechter expects this new down leg will end with the gold price below $200. This pessimistic view will not be greeted with joy by bullish precious metals investors. Prechter has a history of unconventional calls, so at the least our readers have been warned.

The U.S. stock market, according to Prechter is about to resume its major downtrend. His current prediction on stocks is that the next major bear wave might eventually bottom as early as 15 months or as late as 2012 depending on whether there is a panic crash or a long decline like that in Japan. If we were to have a panic crash ending in 2005, it would be the longest bear market suffered so far by American investors. In either case the down leg would be followed by a large multi-year up wave to be followed by one more major bear down wave. Elliott Wave experts have long expected a multi-decade bear market. Any serious investor today will surely need expert Elliott Wave information to understand and deal with these major market cycles.

Please understand that I give this dark picture, not to frighten my readers, but to give you some feel as to what may lie ahead. Prechter also expects there will be a severe depression, worse than that after 1929, which will affect the entire world. I concur in this view because I know our nation is now in much worse shape than in the 1930’s to fight a major depression.

In addition to his prediction that gold will drop below $200, Prechter has repeated his long-held view that the DOW will drop well below 1,000. Of course most observers, especially the gold bulls, reject these extreme predictions. Having purchased my first gold in1971 at $39, and having seen it rise twenty-fold, I am sure that gold will continue its extreme volatility. We plan to present below our ideas on how to protect and keep most of gold’s future gains.

Statistics on bullishness of investors has recently been as high as at the market peak almost 4 years ago. Purchases of mutual stock funds and the amount of leverage in Nasdaq trading have been at very high levels. History is about to repeat and millions of investors will lose heavily as this market resumes its downtrend.

From some of our recent e-mails, it appears that we need to reiterate a few basics regarding long term investing in general and portfolio rebalancing in particular. First of all, most investors cannot imagine the tremendous unknowns that lie ahead and the difficulty of planning and managing a thirty year retirement program. But pity the average buy-and-hold investor following conventional advice. They will very likely lose heavily on the next down leg, be totally bewildered by the succeeding up leg and the final bear down leg, years from now. One needs to start with the very best plan possible and to modify it only when necessitated by circumstances.

One of the problems, or obstacles to success, is the tremendous load of advertising hype we have all received from Wall Street. To believe their story, all you have to do is send them a monthly check and relax until you retire. There probably have been a few lucky people for whom the story came true, but the next 30 years will almost certainly not be like the last 30.

The very best any experienced investor can do is to select the very few asset classes that, since the bear market started almost 4 years ago, have shown the probability of continuing to provide at least modest long term gains. It is unreasonable to expect any asset class to produce gains every year. In fact, it is better to have variations year to year so long as the long term trend is up. This is only true if an attempt is made, through rebalancing, to take these temporary profits and move them to a safe asset class where they will be retained.

In recent months, we have written a number of essays using asset classes we expect to do well in a bear market. From many of the questions received from readers, we have failed to stress some most important points. So we will try again. There are two very important selection criteria for a bear portfolio asset class:

It must have (1) a very high percent of its assets in one selected class, e.g. gold mining and (2) a price history indicating it’s ability to weather bear market conditions. The first requirement is very important since the most desired characteristic is for each asset class to have a unique price action. We do not want to own a fund that owns even two dissimilar asset classes since that will reduce its volatility which provides capital gain opportunities. There are many such funds that, in more normal times, would be acceptable. Fortunately, the requirement for a single asset class is fairly easy to meet initially. If a fund changes its policies at a later date, it should be replaced.

The second requirement cannot be assured for all asset classes except the stable bonds. So, we pick the best ones available at the start and replace any that go into a long losing streak. Any volatile asset will have price cycles that last months in each direction. This is not only acceptable but necessary if we are to create capital gains. In a 10 asset portfolio, one could actually tolerate one class with a long declining price trend provided it continued to provide opportunities to take capital gains from its price volatility actions.

Let’s bring this discussion to a close by summarizing the main features of a multi-asset portfolio designed specifically to provide bear market gains. First of all, it is the very antithesis of a Buy and Hold portfolio. Up to a certain limit, the more times a special bear portfolio is rebalanced, the higher will be the ultimate gains. Our experience has shown that this is especially true if the rebalancing is done at portfolio price peaks and valleys rather than at calendar intervals.

Since the future is unknown, the very best any investor can do is build the best portfolio possible and manage it to the best of his or her ability. There will be three keys to success. First, choose a portfolio size suited to your circumstances, second, select volatile asset classes that are truly different and third, and most important, hold short term government bonds exactly as specified in my essay. They are the essential safe reserve to hold and preserve your capital gains.

Assuming, you have done the best that you can in selecting your portfolio, leave it alone for a year or two. Follow the price actions of each asset class. If it is a small starting portfolio, add new cash periodically to bring the asset classes back to the desired percentages. Moderate size portfolios can best be rebalanced by sale and repurchase of new amounts in each asset class. This can be done readily and at quite reasonable cost in a high discount brokerage account.

Although an investor could make all future decisions based solely on the price actions in the portfolio, it will always be helpful to have access to long term Elliott Wave data. At some time in the future, the huge first great bear wave down will end and be followed by a major corrective wave. It will show up in the prices of the short funds but not necessarily in the bonds, gold or natural resource sector. If expert EW predictions at the time call for more than a year or more of rallying, the three short funds could be traded for long index funds to be held for the length of the corrective wave and switched back for the next bear leg. Do not attempt to do this without good information. If the next bullish leg in a long bear market turns out to be relatively minor the short positions could be retained. Please remember that our retrospective portfolios have survived bear market rallies as long as 11 months.

After doing a superb job of selecting the best available asset classes, a wise investor would then determine the percentage of cash allocation to each. This will determine the overall safety of the principal and the expected amount of growth and price volatility. If the investor has done a good job of fixing these variables, a serious investor would want to retain these important portfolio characteristics permanently. Many investors forget about the huge changes that will occur over a five or ten year period. Some parts of the portfolio might grow to several times the original percentage with other assets declining. Periodically returning a portfolio to its original asset balance is the easiest and best way to keep its original asset percentages. This is the only way to keep a well planned portfolio working to achieve a long term objective.

Without a rebalancing plan to guide them, many investors may lack the discipline to handle success or failure in one or more parts of their plan. Let’s suppose a huge gain occurs in the precious metals class over a two year period, followed by a complete retracing of the gains. It would be difficult for experienced investors to recognize the peak and take some or all of the profits. But a planned rebalancing every six months would capture much of the gains and save much of the ultimate loss. So, the best argument in favor of periodic rebalancing is that it forces investors at all experience levels to take profits when available and prevents them from disappearing or even turning into future losses.

In summary, rebalancing is a simple way to manage a long term portfolio and bring it to a successful conclusion. It forces each investor to follow the original plan to a successful end or until future events dictate that changes need to be made. Rebalancing is of great importance to preserving your capital and to capturing capital gain opportunities before they disappear in normal market ups and downs.

To clarify my words above, we will give the actual experience of rebalancing the portfolio discussed in our Essay No.1 several weeks ago. Viewing the FastTrack price charts of these stocks and funds over the past 3 years, it was apparent that there were 6 very sharp price peaks, 3 in the reverse NASDAQ short fund and another 3 in the ASA closed end gold fund. We chose to rebalance at each price peak, even though, in real time, a delay of one week might occur to recognize that a peak had occurred. So the differences in the assets before and after rebalancing are slightly magnified to make them easier to follow. Data on the 6 price peaks is given below:

Asset Class	Date	Price High	3 Year Price Range
Reverse NASDAQ	04/04/01	40.74	20.46 - 52.46
Reverse NASDAQ	09/21/01	45.15	20.46 - 52.46
Reverse NASDAQ	10/07/02	52.46	20.46 - 52.46
ASA Gold Fund	06/03/02	38.88	15.25 - 44.80
ASA Gold Fund	01/03/03	42.19	15.25 - 44.80
ASA Gold Fund	09/24/03	44.80	15.25 - 44.80

Here is the 3 year comparison from 10/06/2000 thru 10/06/2003 for the identical portfolio with and without rebalancing:

		Total Value on 10/06/2003
Asset Class	Initial Portfolio	Buy and Hold	6 Rebalances
U.S. Tr. Short Bonds	$26,000	26,670	$38,412
Foreign Short Bonds	26,000	37,632	38,412
ASA Gold Fund	6,000	15,956	8,864
CEF Bullion Fund	6,000	8,784	8,864
Small Gold Fund	6,000	9,332	8,864
Rev. Nasdaq Short	6,000	7,961	8,864
Rev, S&P 500 Short	6,000	7,455	8,864
RYJUX Short Bond	6,000	4,696	8,864
PCL Timber Stock	6,000	8,482	8,864
Divers. Energy Fund	6,000	8,761	8,864
Total	$100,000	$132,327	$147,739

The annualized rate of return for Buy and Hold is 9.8% and for Rebalancing is 13.9%. This differential will certainly vary with different asset classes and market conditions. But there are real advantages to rebalancing that have nothing to do with the final return. An unmanaged buy and hold portfolio has the ever present danger of major losses if one or more assets grow to a high level and then crash. This is always possible when dealing with volatile asset classes and inadequate management attention. If you choose to rebalance twice a year, using price peaks as in this example, you will always be an active manager and will have very few negative surprises.

It is interesting to note that all the reverse index stock funds have been dropping in price for the past year, but the rebalancing actions have added funds from other capital gains that will be of great benefit when the general market resumes the bear trend. Also note that ASA and CEF had significant price peaks on September 24, 2003. Only one of the asset classes, Foreign Government bonds, closed on October 6, 2003 at its 3 year price high. The short stock funds topped on October 7, 2002. Presumably their next big price move will be up. My personal conclusion from this retrospective test is that this portfolio will continue to do well as the bear market continues. With its large and safe bond component, its volatile components are expected to follow their past volatile habits and provide future capital gains as in the example above.

We have been thru a turbulent bear market and expect it to continue. However there can be no guarantees for the future. It is one thing to put some "play" money into a portfolio and quite another to put your retirement assets at risk. However, if you choose assets well and continually look for any adverse market developments and make necessary changes, there is no reason why you should not sleep well at night.

As we close this essay, the market appears to be in the final blow-off stage of this one year bear rally. We fully expect it will end badly for all participants. My advice to all readers is (1) to avoid this mass mania and (2) set your objective on safe, steady growth over the long term. Best wishes for your future success.