FSO Editorials: Planning For a Long Bear Market by Robert B. Gordon 08/16/2004

Planning For a Long Bear Market
The Going Gets Tougher
by Robert B. Gordon, Sc. D.
August 16, 2004

One of the hardest jobs for even an experienced investor is to make the intellectual change from a bull market to a bear market climate. In a bear market most equities are going down in price with occasional rallies. Of course, with thousands of stocks, there will always be some that are in their own small bull market. These will be very hard to find and own for profits. The great run of mutual funds are also unable to own enough stocks with rising prices so there are very few equity funds with rising prices.

And, after a very long bull market, most mutual funds are still carrying very small cash balances. This habit will have severe consequences for the investors who continue to hold these shares. Despite this obvious fact, Morningstar recently stated its criticism of mutual funds who held heavy cash reserves. They are the very funds I admire because of their high cash positions. The heavy cash will help to protect the fund investor’s cash. As in the past, only a few funds are adopting a heavy cash position because the others are greatly underestimating the severity of the market decline that lies ahead.

Short term bond funds may present some chance of rather low returns. Longer term bonds will not do well if interest rates are rising. So we are left with a limited number of investment choices. The first and surest choice is the growing group of short funds. A second and limited choice is represented by the Hussman Growth and Income funds which use options to nullify losses in their main holdings.

Finally, we come to our favorite Permanent Portfolio fund with 6 asset classes which have produced quite stable fund prices over the past 30 years. We do believe that it will need some help from other funds such as short funds to get safely through the present severe bear market climate. The use of short funds gives us the capability to use funds in the class we call Long Term Stable to augment the two Hussman funds and the Permanent Portfolio.

Young investors or adults just starting may have a somewhat easier job in building a bear market portfolio in that they are free of old bull market habits, but they still have to deal with the relative scarcity of investment vehicles. In this essay we will try and illustrate just about all of the favored candidate assets in a variety of portfolios.

Although the returns from the Hussman Strategic Growth fund and the Hussman Total Return fund have dropped somewhat recently, they are still showing fairly good returns since their start date. If they continue to grow in asset size as fast at they have so far, they may run into some problems. But they are still worth including in a bear market portfolio.

Another important part of a portfolio can be given to short term U.S. Treasury and Foreign government bond funds. I prefer to own these bonds in equal parts to hedge against a loss in the value of the U.S. dollar. We thus have a total of 4 asset classes which make up the total of the stable asset classes.

By reading his weekly reports on the internet, we know that Dr. Hussman has been having trouble matching his hedge position with his current growth fund portfolio, the result being a 7% drop recently. Over the past 12 months, here are the returns for the four stable asset classes:

     Hussman Growth                  6.3%
     Hussman Income                  9.4%
     Prudent Global Income          6.1%
     Intermediate term Treasury    5.1%
     Inflation Protected Treasury 11.7%

So we are reminded once again that all securities, even those we call stable, do vary in price in a bear market climate.

This class includes those mutual funds and stocks whose price may vary as a result of a temporary price dip but which are expected to be stable over the long term. The list includes the Permanent Portfolio fund, many highly rated conservative funds in Morningstar’s conservative and moderate allocation group such as FPACX etc. It also includes funds with a solid history such as FDFAX and stocks like PCL and WTR with long term growth prospects.

These asset classes require that the portfolio using them must be rebalanced periodically to capture the profits from growing asset classes and keep the original portfolio composition. This is very important and has been discussed many times in previous essays.

We have given many examples of volatile asset classes such as gold and silver, oil and gas in previous essays but have not been putting them in recent portfolio examples because we wanted to concentrate on more stable portfolios.

As this bear market progresses and investors become better experienced reacting to its ups and downs, there will be plenty of time to add volatile asset classes which can add substantially to a portfolio’s profits.

Recently, we have been recommending a short fund allocation for almost every portfolio because, with the resumption of the bear market, it is the surest way we know to realize profits. As this bear market progresses, we hope that many investors will use one or more bear funds to help build profits in a very difficult market.

I will be suggesting using up to 4 different short funds to profit from their different objectives. Anyone, irrespective of previous experience, using such a portfolio will very quickly learn to appreciate their differences and advantages in adding profits in a bear market.

The first thing every investor must do is forget just about everything that worked in a bull market. Bear markets may begin slowly and softly, but eventually are capable of taking nearly every penny if you do not shift all your assets from a bull to bear plan. The Hussman Growth Portfolio is undergoing a severe test of its hedging actions according to this week’s report from Dr. Hussman. Of course it will always have an advantage over any unhedged fund and will remain a valuable fund to hold in your portfolio if it has some downside protection from short funds.

A successful bear market plan requires very careful selection of asset classes. We will illustrate this in several conservative portfolios running from basic to fully developed. Please remember that I consider a short position is required and that any amount up to 30% is a desirable component of a bear market portfolio.

This is the simplest portfolio I can recommend for the bear market condition. However, it can not be left without management attention at market bottoms and tops as discussed below.

	Ann. Gain 11/21/2000 to 08/12/2004	Weighted Gain 11/21/2000 to 08/12/2004
Stable Component 70% HSGFX	13.1%	9.2%
Short Component 30% BEARX	12.3%	3.7%
100% Total		12.9%

Although the Hussman Growth fund may grow in both up and down markets, BEARX will only grow in down markets, The investor must rebalance at the market bottom and transfer that gain to the stable fund or it will be lost in large part during the trip to the next market top. In fact the surest way to handle this small portfolio would be to sell BEARX at the bottom and buy it back at the next market top. This will insure that the large bear market gain will all be saved and reinvested at lower prices.

	Ann. Gain 11/21/2000 to 08/12/2004	Weighted Gain 11/21/2000 to 08/12/2004
Stable Component
60% HSGFX	13.1%	7.9%
Short Component
10% BEARX	12.3%	1.2%
10% RYAIX	-3.1%	-0.3%
10% RYURX	-1.8%	-0.2%
10% RYJUX	-8.2%	-0.8%
Grand Total		7.8%

You may well ask, why did I include this example which is doing so poorly as shown above? The answer is that the final result would have been much, much better with a rebalancing at the major market bottom from the spring of 2002 to the spring of 2003. Go to any web site that can chart the short funds and see their high price peaks during that 12 month period. These large profits should have been transferred to HSGFX and then recently transferred back to the short funds which are starting their rise in the new bear market leg.

	Ann. Gain 01/02/2001 to 08/12/2004	Weighted Gain 01/02/2001 to 08/12/2004
Stable Component
10% HSGFX	13.4%	1.3%
10% HSTRX	7.4% *	0.7%
10% Int. US Treas.	6.8%	0.7%
10% US Infl. Prot.	10.4%	1.0%
10% For. Gvt. Bnd.	11.2%	1.1%
50% Total		4.8%
Stable Over Long Term
20% Perm. Portfolio	11.0%	2.2%
Short Component
10% BEARX	11.1%	1.1%
10% RYAIX	-0.2%	-0.0%
10% RYURX	2.3%	0.2%
30% Total		1.3%
Grand Total		8.3%

The above results do not look very exciting so let’s look at the past 6 months performance.

	Ann. Gain 02/12/2004 to 08/12/2004	Weighted Gain 02/12/2004 to 08/12/2004
Stable Component
10% HSGFX	-9.4%	-0.9%
10% HSTRX	0.6%	0.1%
10% Int. US Treas.	1.2%	0.1%
10% For. Gvt. Bnd.	-8.8%	-0.9%
10% US Infl. Prot.	6.6%	0.7%
50% Total		-0.9%
Stable Over Long Term
20% Perm. Portfolio	-1.0%	-0.2%
Short Component
10% BEARX	-6.2%	-0.6%
10% RYAIX	24.8%	2.5%
10% RYURX	13.6%	1.4%
30% Total		3.3%
Grand Total		2.2%

Despite excellent performance from the inflation protected U.S. bonds and two of the short funds, this portfolio performed very poorly. Let's try again and show the recent 3 month performance.

	Ann. Gain 05/12/2004 to 08/12/2004	Weighted Gain 05/12/2004 to 08/12/2004
Stable Component
10% HSGFX	-14.0%	-1.4%
10% HSTRX	18.3%	1.8%
10% Int. US Treas.	17.7%	1.8%
10% For. Gvt. Bnd.	15.1%	1.5%
10% US Infl. Prot.	22.7%	2.3%
50% Total		6.0%
Stable Over Long Term
20% Perm. Portfolio	22.7%	4.5%
Short Component
10% BEARX	2.1%	0.2%
10% RYAIX	33.6%	3.4%
10% RYURX	10.6%	1.1%
30% Total		4.7%
Grand Total		15.2%

I believe this is the first time I have given the performance of a single portfolio over 3 different time periods. It should be studied as an important lesson in investor patience. If you have chosen the portfolio’s components carefully, you must give it some time to prove its worth. The 3 1/2 year period was hampered by having two unmanaged short funds who performed well in down markets and poorly in up markets. The overall results would have been much better with proper management of the short funds.

The recent poor performance of the Hussman Growth fund may turn out to be a temporary measure as the manager revises his hedging strategy. During the earlier down market period, the fund had much smaller assets which may have been easier to hedge effectively. My guess is that Dr. Hussman will learn how to hedge his present funds size, so we will continue to read his weekly messages and see how he solves the current problem.

If your portfolio is not acting well, please write for help. No investor should continue to keep a portfolio which is ill fitted for the tough market ahead. Of course, I always like to hear about a portfolio that is doing well in this bear market. If you do have a losing portfolio, do not delay another day in selling all or part to stop the losses. Remember, this second leg of the great bear market has barely started. It has a very long way to go.