Bear Market Rally No. 1 and Beyond

Bear Market Rally No. 1 and beyond... Smaller first, bigger later... How Evil Mr. Market sets his traps... The rally might be over already... What you can do now... Hedging with bonds... Hedging with commodities... An unsatisfying answer...

'Now what?'

I (Dan Ferris) asked my Stansberry Investor Hour podcast listeners that question earlier this week.

Now that it looks like a bear market rally has begun... what happens next?

Regular Digest readers know that I normally avoid this type of question. I hate the whole idea of basing an investment strategy on trying to predict the future.

That just seems like a recipe for disaster.

As I've often said, it's better for investors to prepare for the future than try to predict it.

I'm unlikely to change my mind about that.

But in today's Digest, we'll start with a look at some historical data. As you'll see, I believe it can help you prepare for a scenario that's becoming more likely by the day.

In short, as investors, this fundamental rule is important... To look ahead, look back.

History can be an excellent guide to the future...

That's why I often refer to past market cycles as guides to understanding the present.

In fact, I recently saw two interesting charts of bear markets from two key historical eras – the dot-com bust from 2000 to 2002 and the Great Financial Crisis from 2007 to 2009.

Researchers at financial-services company Piper Sandler looked at the number and size of bear market rallies from both eras. And the results reveal an intriguing trend...

Piper Sandler identified six bear market rallies in the dot-com bust and five rallies during the Great Financial Crisis. In comparing the two sets of data, a striking pattern emerges...

It's obvious, isn't it?

The bear market rallies later in the cycle were noticeably larger than the initial ones...

Investing is an art, not a science. So I'll just give you my artistic interpretation of the earlier rallies in each bear market...

The early rallies were small for a simple reason. In each bear market, investors became indoctrinated to being bullish and buying every dip for several years leading up to the top.

So in the start of the downturn, Evil Mr. Market didn't need to work hard to entice stubborn bulls back in before punishing them again. As a result, the early bear market rallies were shallow.

But after burning investors too many times, Evil Mr. Market needs to work harder...

The later rallies needed to be larger in order to keep luring beleaguered, increasingly bearish investors before crushing them again.

Sooner or later, investors capitulate. Evil Mr. Market appears to get the best of them. And many folks give up on stocks for years. That's when the bottom finally occurs.

Bear market price action is characterized by a series of lower highs and lower lows.

Without getting into technical gobbledygook, I imitated Piper Sandler's method of measuring bear market rallies to see where we are right now. Here's what that looks like...

If that 7.1% rally on the far right doesn't impress you, I agree. It looks downright puny!

But now, look back at the list of rallies from the dot-com bust and Great Financial Crisis...

The first rally in both bear markets was 7.7%. Three of the four initial rallies over those two periods didn't eclipse 10%. And here's the thing... If the current rally ends after another 0.6 percentage points higher, it would match the first rally of those two extended bear markets.

Coincidence? Maybe.

I don't think it's reasonable to expect them all to be identical. History rhymes more often than it repeats, after all.

But keep your expectations in check... Until Evil Mr. Market tells me I'm wrong, I expect Bear Market Rally No. 1 to be small. As you read these words, we might only be a day or two away from the start of the next big leg down.

Even worse, if history is rhyming right now, the rally might already be over...

I don't do predictions, but I like to understand risks and prepare for a wide set of outcomes.

And today, we need to contemplate the risk that this bear market will play out similarly enough to the most recent two bear markets (not including the one-month crash due to COVID-19 in early 2020).

Of course, I can hear the keyboard cowboys already typing furiously. They're probably objecting to my attempt to assign statistical significance to these two scant data sets – each consisting of a mere handful of data points.

If you write in to complain about that, I won't disagree this time. I just don't think it matters... As I said earlier, investing will always be more art than science. After all, it's about the behavior of human beings, not the behavior of energy or matter.

So far in today's Digest, I'm just saying that these two historical episodes suggest investors who had reaped big gains for years behaved a certain way when the trends went into reverse. And human nature being what it is... I believe folks will repeat those behaviors this time as well.

It's like the way a moth flies through a flame again and again.

So if I'm right, you'll need to know what to do about it...

Most folks should focus on survival and adopt my "prepare, don't predict" mantra. If you've done that, you're probably already doing all you can...

You're probably already selling garbage assets of all kinds, holding plenty of cash, holding gold and silver, and continuing to hold great businesses for the long term.

Regular Digest readers will recognize that prescription. I repeat it often to emphasize that the main scenario you've prepared for has arrived and this little rally changes nothing.

Stay the course, steady as she goes.

If you're more of a risk taker and want to see if you can make money off this bear market, then you don't need me to tell you what to do. Tally-ho, and good hunting.

Many investors will want to buy some kind of hedge. They'll want to have an insurance policy against Evil Mr. Market's further destruction.

So let's talk about two primary methods of doing so...

One of the most popular traditional hedges against Evil Mr. Market is buying U.S. Treasury bonds...

This strategy has been a classic equity hedge over the past few decades.

The basic idea is that investors retreat to the safety of bonds when stock prices decline. It's the foundation of the oft-cited "60-40 portfolio," which is 60% stocks and 40% bonds. The bonds are included to help investors reduce any overall portfolio volatility caused by stocks.

But the problem is... it's not working this time.

(My colleague and Digest editor Corey McLaughlin has touched on the growing problems with the 60-40 portfolio several times. The February 15 Digest is just one example.)

So far this year, the iShares 20+ Year Treasury Bond Fund (TLT) has declined along with the S&P 500 Index. In fact, TLT is performing worse than the S&P 500. Take a look...

Now, it's possible that these joint declines for TLT and the S&P 500 are temporary due to inflation. That's a threat to all our money. It hurts returns for both bonds and stocks.

And according to data published earlier this week from chart-based, online newsletter The Daily Shot, bonds have generally performed well after both bonds and stocks have declined.

But then again, maybe it's not temporary.

You see, most of the cited episodes in The Daily Shot's data occurred during the 42-year-long bond bull market from 1980 to the present. (It remains to be seen if it's really over.) So maybe this information is just another way of saying that you can buy the dips in a bond bull market – just like you can with stocks. That is... until it doesn't work anymore.

Here in the Digest, my colleague Doc Eifrig previously shared data from Artemis Capital Management about the longer-term trends between stocks and bonds. The firm found that stocks and bonds have mostly correlated positively over the past century or two. In other words, they mostly rise and fall together – making bonds a poor hedge for stock declines.

So perhaps the success of the 60-40 portfolio really was just the result of the long-running bond bull market. Maybe that period is over now. Maybe bonds will revert to their previous tendency to rise and fall with stocks.

And of course, if you believe elevated inflation is sticking around and that the Federal Reserve will raise interest rates for the rest of this year... then you must also assume bonds will continue to be a poor hedge against declining stock prices in the near future.

When stocks perform poorly due to inflation, another asset class is a better choice...

Commodities can act as a great hedge for investors – under the right conditions, at least...

To see what I mean, let's go back to the inflationary 1970s...

The following chart compares the S&P GSCI benchmark commodity index and the S&P 500 in terms of percentage gains throughout that decade. As you can see, commodities finished the decade 138% higher than they started. But the S&P 500 only finished 17% higher...

Commodities clearly outperformed stocks in the 1970s. But if you take a closer look at the above chart, you can see some problems with simply buying commodities at any time...

First, assuming history rhymes, the peak in the S&P GSCI in 1974 suggests that investors need to get into a commodities boom early. Otherwise, they could miss the biggest gains...

The index exploded higher from 1972 through late 1974. But then, it mostly drifted sideways or down for the rest of the decade.

Investors who held on throughout the whole period would've ended up with roughly the same gains as folks who sold in mid-1974. And they would've had noticeably less gains than if they would've sold at the peak toward the end of that year.

Second, the volatility of the line across the entire chart suggests that it's hard to hold on to commodities. Prices ratchet up and down sharply over short periods of time.

These days, the S&P GSCI has nearly tripled off its COVID-19 bottom. It's two years into an uptrend. And it's worth noting that the index's trajectory since Russia invaded Ukraine in late February has been both ballistic and highly volatile.

In commodities, you're either a contrarian or a victim. And if we step back and look at the S&P GSCI over the past 20 years, it's really hard to feel like a contrarian right now...

Remember, oil is the world's most actively traded commodity. It's also the largest component of most commodity indexes (including the S&P GSCI). And it tends to influence the prices of other commodities, which require oil and gas for production and transportation.

Anybody can see the maximum fear about oil supplies in headlines all over the world these days. And we're two years into a massive rally in commodities – with a massive, nearly vertical spike lately.

With all that in mind, the best time to be a commodity contrarian seems to be in the past.

Now, I'm not saying that oil prices won't go higher from here. In fact, that wouldn't surprise me at all, given the insane persistence of the global political class to push its "green" agenda. Continued supply disruptions from the war in Ukraine won't help, either.

So if you want to bet on higher oil prices, I won't disagree with you. But my point is that it's more of a speculation today than a well-timed hedge to protect your wealth for a few years.

If bonds and commodities aren't good equity hedges right now, you're likely wondering where to turn...

WARNING: Horribly unsatisfying answer ahead.

I hate to say it because it sounds like I'm chickening out. But right now, as we live through Bear Market Rally No. 1, the only answer for most folks is to hold a lot of cash.

It sounds like I'm chickening out because most people should do that with at least some of their money anyway. They should be doing whatever they can to survive the bear market.

But if I'm right about the bear market, most people will behave horribly for the next year or two. Instead of preserving their cash for brighter days, they'll repeatedly let Evil Mr. Market sucker them in... only to lose more of their wealth when he punishes them again.

Cash is the asset that most people understand best. They can count on it. And they know what it will be worth a week, a month, or a year from now (minus a little bit for inflation).

If you're confident in your ability to trade without blowing up and you would rather buy put options or sell stocks short, good luck.

But a bear market is a lousy place to mess around if you're not a confident, experienced trader. If you don't know what to do and need guidance... hedge by holding plenty of cash.

How much?

That's up to you. Every investor's situation is different. You'll want to hold however much you need to sleep well at night and not obsess about your financial assets every day.

In fact, I strongly believe that the most important core skill an investor must have to succeed over the long term is the ability to hang onto a large sum of cash indefinitely.

Yes, you read that right. And you should probably read it again and burn it into your consciousness for all time...

If you can't sit on cash and wait, you'll likely never be able to sit on the equity of a great business while it compounds at high rates over the long term and suffers a few drawdowns here and there. It takes a lot of discipline.

I've said before that 'the learning of life is about what to avoid'...

That quote comes from author and trader Nassim Taleb. It relates to his concept of "via negativa." That's Latin for the "negative way."

Well, holding cash means not spending it. It's a negative skill. It's about learning what actions not to take more than what actions to take. It's about avoiding actions that could lead to negative consequences.

Avoiding disasters in life is more important than any successes. If you fail to avoid disaster, you could lose your life early. And that would eliminate any chance of future success.

Bear markets aren't about maximizing your gains. You do that in bull markets. Bear markets are where you demonstrate your ability to minimize loss.

The essence of any effective bear market investment strategy is survival...

Before you can do anything else with your portfolio throughout a bear market, you need to survive. And depending on your situation, your ability to grow substantial wealth could be permanently diminished if you fail to survive (financially speaking).

As long as you're confident in your long-term strategy, you should continue to follow it. But you also need to be ready for panicky moments when asset prices go into freefall...

At those times, looking at your 401(k) account might give you heartburn. But by holding a big slug of cash, you'll likely still sleep soundly at night.

You'll also do well if you listen to my colleagues who've been down this road before...

Earlier this year, Stansberry Research publisher Brett Aitken challenged our world-class team of editors and analysts... He needed us to help you prepare for the bear market.

Our research team boasts hundreds of years of combined market experience. We've navigated almost every crisis you can imagine – from the 1970s oil shock to the present.

And together, we developed Stansberry's Financial Survival Program...

This seven-module program details everything you need to know to survive today. Every module includes ways to protect your savings and give you relative safety and stability amid the current whiplash of war... inflation... and the rumblings of a devastating bear market.

You'll find out exactly how to position yourself, step by step. It doesn't involve any panic or hysteria. You'll simply get clear, actionable recommendations in every module. They're designed to help you navigate this dangerous environment.

Again, we developed our Financial Survival Program from the best ideas across the entire Stansberry Research universe. Normally, it would cost tens of thousands of dollars to access everything. But right now, you can claim instant access to all seven modules for just $299. Get started right here.

New 52-week highs (as of 6/2/22): Enterprise Products Partners (EPD), Texas Pacific Land (TPL), Viper Energy Partners (VNOM), and SPDR S&P Oil & Gas Exploration & Production Fund (XOP).

In today's mailbag, a subscriber writes in about some of our old favorites. What's on your mind? As always, you can tell us at feedback@stansberryresearch.com.

"We have spent a lot of time discussing inflation over the past many months. Perhaps it's time to remind everyone of the Uncle Eric book series. I'm not certain of this but I could swear that I found out about this book series by reading something from Stansberry, perhaps many years ago from [Stansberry Research founder] Porter [Stansberry]? The series description intrigued me, especially when I learned that the author [Richard Maybury] was from my own little hometown north of Cincinnati.

"I purchased the entire series and over the years I have reread every book several times. In fact, I'm rereading them at present. The author did a fantastic job of research in this series and he explains topics like inflation in such easy-to-understand terms using historical and present-day examples. (Note that he is still alive and has a monthly Early Warning Report, which he still publishes.)

"The second book in the series is called Whatever Happened to Penny Candy? and once a person reads this, he will be much better armed in the investing community. When I learned that we were going to print a whole bunch of currency a couple of years ago, I rushed out and purchased a good stock of precious metals and began tilting my portfolio towards commodities, commodity-related businesses and miner stocks. Through what I learned from people like Doc, Porter and Mr. [Commodity Supercycles editor Bill] Shaw there at Stansberry, I have benefited greatly from this sector by trading options and stocks.

"I could go on, but I thought that I learned of this series from Stansberry and since I am from the generation of the '70s where I was once told by a banker that 'the days of fixed mortgages were gone' and that I should sign up for his 17% variable rate mortgage, that you should remind readers of this great book series and tell them where to buy it. They won't be sorry.

"Thanks for what you do." – Paid-up subscriber Rob W.

Corey McLaughlin comment: Rob, thank you for the note. This is a great idea to share... and I'm willing to bet your hunch about hearing about Maybury's work from us is correct.

A lot of folks in our office believe the Uncle Eric series should be required reading in every school in America.

Over the years, several of our analysts and editors have frequently recommended Maybury's writings... he appeared as a guest on the Stansberry Investor Hour podcast... and we even published a few of his essays and interviews in our weekend Masters Series.

You can find those pieces by searching for his name in our Digest archives.

Most recently, Doc named two of Maybury's books – Whatever Happened to Penny Candy? and The Clipper Ship Strategy – as two of his "favorite things of 2021." Doc said he planned to give the books to his young family members this year.

As Doc wrote in his free Health & Wealth Bulletin newsletter late last year...

Richard is a longtime writer of political and economic history as well as a newsletter publisher... I find his common-sense take refreshing and real. He's one of the greatest free-market thinkers and writers that I know.

As this market and the world around us get crazier and crazier and as governments print their way into power, his take on economics and war will be invaluable for my nieces and nephews!

So again, Rob, thanks for sharing the timely recommendation. We're happy to pass it along. Interested Digest readers can learn more about the books on Maybury's website here.

(And as a disclaimer, we do receive a very small amount for anything purchased through the Amazon links we cited above. But rest assured that it has no bearing on our recommendations. We're just fans of the work.)

Good investing,

Dan Ferris
Eagle Point, Oregon
June 3, 2022