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Taming the Bear: The Bright Side of Bear Markets

Despite all of the gloom and doom discussed above, I urge you to embrace bear markets as opportunities, as recurring market phenomena that can't be effectively avoided.  We've always had bear markets, through all of which stocks have still managed to return about 10% per year on average over the last century.  And we always will have bear markets as long as human beings and their emotions hold sway.

This is the bright side of bear markets:

* Bear markets present the opportunity to harvest tax losses in taxable investment accounts.  I happen to believe that the benefits of tax-loss harvesting are often overstated, and particularly in a low-interest-rate environment.  However, if you can combine tax-loss harvesting with upgrading your portfolio by substituting one investment holding for another while steering clear of the "wash sale" rules, then bear markets allow you to kill two birds with one stone.

* And on the topic of upgrading a portfolio, bear markets inevitably present opportunities to buy closed-end funds at considerable discounts to their intrinsic values. Because CEF's tend to have relatively small numbers of shares outstanding, they tend to be dismissed by institutional investors and are favored by income-seeking, but on the whole unsophisticated and fickle, retail investors.  When the going gets tough in the financial markets, they tend to bail out, almost without regard to price, leaving bargains behind in the process.

* As alluded to above, bear markets, and the performance disparities among asset classes that often accompany them, provide opportunities to rebalance portfolios back to their target asset allocations.  And portfolio rebalancing is one of the rare opportunities in finance to increase returns while reducing risk.

* Roth conversions become more attractive in bear markets.  The tax bill associated with converting a given IRA or retirement plan account to a Roth account varies directly with that account's total value.  As account balances decline (and as future expected returns increase) in bear markets, converting accounts to Roths becomes cheaper and more attractive.

* And future expected portfolio returns should increase during a bear market.  This relationship is more obvious in bond bear markets, since there is an unequivocal relationship between falling bond prices and rising bond yields.  And academic research suggests that the best predictor of future total returns on bonds or bond funds is their current yield.  

But stock bear markets display a similar dynamic.  Current stock market valuations, using whatever metric you prefer (aggregate market value-to-sales, aggregate market value-to-earnings, aggregate market value-to-GDP, etc.), are predictive of future returns.  The lower the market's current valuation, the higher the subsequent returns, and stock bear markets compress valuations.  In this respect, stock market returns are cyclical.  Prolonged periods of subpar performance tend to be followed by extended periods of strong returns.

"Above all, investors must remain disciplined and patient, as always, but more specifically if they believe rates will continue to rise".

--- yours truly, in a recent CNBC.com article

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.

Contact Paul