The Bear Market Project

By Scott Lummer
Chief Investment Officer, mPower

Many young investors have heard tales of the "Bear Market." Since they have never seen it for themselves, they think it is a myth. But it's not, as the following column shows. (The column is set a few years in the future. Since my time machine occasionally malfunctions, this column is an illustrative example and does not attempt to portray market events exactly as they will happen. Also, it is extremely scary, so read it at your own risk.)

***

This column depicts an event that took place outside a small investment advisor's office in Maryland.

The time is April 2003. Two years ago, three young cynical analysts (we'll call them Brian, Heather and Greg) set out to prove that the legendary "Bear Market" did not exist. Although they have heard tales of the Bear Market gobbling up investors' portfolios in the past, their vast experience (after all, they have been investing for 10 years) convinced them that the Bear Market was either purely fictional, or had long since died off.

It's true, over the past two decades there have been occasional phenomena suggesting that the Bear Market was indeed up to its old tricks. There was the time back in 1994 when little Evan Robinson went wandering into the exchanges, and his portfolio completely disappeared. However, the three young analysts convinced themselves that this event was so minor as to be trivial.

Before that, there was the mysterious "Black Monday" of 1987, when thousands of investors reported being harmed by the Bear Market. Our three brave analysts were troubled by that event, but noted that it was short-lived, and pointed out that the investors who had sufficient provisions to remain in the exchanges came out unscathed. Emboldened by such research, the bullish threesome were determined not to be swayed by the myth of the Bear Market, and started investing aggressively in early 2001.

Heather, Brian and Greg did not begin their search for investments completely unprepared. They were ready to accept some losses, and felt that they might be able to withstand a short-term hit of as much as 25%. Initially, even this seemed unnecessary, since their portfolio earned money during the first quarter.

Supported by their initial findings, they became reckless, eschewing the traditional benefits of a diversified portfolio and wandering into the area where the Bear Market poses the greatest threat -- high price-to-earning ratio (growth) stocks. Only Greg, the least convinced of the three, was shaken by a 10% decline in stocks during a single week in May 2001. He stayed in the field after being chastised by the leader, Heather. She seemed to be proven right when stocks recovered during June and the group's portfolio was up by a large amount for the year.

Then weird things started to happen. Productivity, which had been steadily improving since the early 1990s, began to level off. Signs of inflation began showing up. The growth of the Internet and computer sectors started to creep downward, into single digits. And for the first time in a decade, Microsoft announced earnings below expectations. For the year 2001, stocks in general were down by 9% -- their first decline in seven years.

Our intrepid trio still held fast to their belief that these were natural occurrences and that the Bear Market did not really exist. However, in May 2002, the Fed raised interest rates for the third time in less than a year, and the market fell another 8%. Moreover, although stocks as a whole were down 17%, our heroes' portfolio had fallen by 24%.

At this point, Greg disappeared. No one knows where he went, but remnants of his brokerage statements were found near a bank selling certificates of deposit.

Brian and Heather, although shaken by Greg's disappearance, vowed to continue on. But the market free fall did not stop. In November, economic figures showed that inflation was on the rise while employment was falling. Major companies announced layoffs, and consumer confidence fell to its lowest level in 20 years. By the end of the year their stocks had fallen an aggregate 38%, and Brian and Heather has lost 52%.

Heather lost track of Brian and was forced to weather the storm alone. In an emotional note to her family, she apologized for losing so much of their money. Then, although there were some signs of stability from international and basic manufacturing stocks, Heather stopped accessing her online portfolio tracker. In the end, she had lost nearly 60%, and, apparently, her will to continue.

***

Back to 1999.

O.K., so that was a bit melodramatic. But my concern is that many investors are substantially underestimating the potential volatility of the stock market. Moreover, they are increasing their risk by taking large positions in particular sectors. Some investors may be unaware of how far a market can drop (to see an example, visit our "Bear's Cave") while others may feel that risks are lower in today's market. Well, everyone is entitled to his or her opinion, but I see no evidence that stocks are any more stable now than they were in the 1970s.

I am not literally predicting that there will be a huge market downturn in the next few years. Nor am I suggesting that investors should get out of the stock market -- in fact, all of my money is in equities. However, it is vital to be broadly diversified across various sectors, and to be aware of the risks you are taking. The problem with underestimating stock market volatility is that a sustained downward move for which you are not prepared could cause you to pull out of stocks at the worst possible time -- the bottom of the market.

Now if you'll excuse me, I've got to get back to work on my column based on "Boogie Nights."

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

The Bear Market Project

By Scott Lummer
Chief Investment Officer, mPower

Many young investors have heard tales of the "Bear Market." Since they have never seen it for themselves, they think it is a myth. But it's not, as the following column shows. (The column is set a few years in the future. Since my time machine occasionally malfunctions, this column is an illustrative example and does not attempt to portray market events exactly as they will happen. Also, it is extremely scary, so read it at your own risk.)

***

This column depicts an event that took place outside a small investment advisor's office in Maryland.

The time is April 2003. Two years ago, three young cynical analysts (we'll call them Brian, Heather and Greg) set out to prove that the legendary "Bear Market" did not exist. Although they have heard tales of the Bear Market gobbling up investors' portfolios in the past, their vast experience (after all, they have been investing for 10 years) convinced them that the Bear Market was either purely fictional, or had long since died off.

It's true, over the past two decades there have been occasional phenomena suggesting that the Bear Market was indeed up to its old tricks. There was the time back in 1994 when little Evan Robinson went wandering into the exchanges, and his portfolio completely disappeared. However, the three young analysts convinced themselves that this event was so minor as to be trivial.

Before that, there was the mysterious "Black Monday" of 1987, when thousands of investors reported being harmed by the Bear Market. Our three brave analysts were troubled by that event, but noted that it was short-lived, and pointed out that the investors who had sufficient provisions to remain in the exchanges came out unscathed. Emboldened by such research, the bullish threesome were determined not to be swayed by the myth of the Bear Market, and started investing aggressively in early 2001.

Heather, Brian and Greg did not begin their search for investments completely unprepared. They were ready to accept some losses, and felt that they might be able to withstand a short-term hit of as much as 25%. Initially, even this seemed unnecessary, since their portfolio earned money during the first quarter.

Supported by their initial findings, they became reckless, eschewing the traditional benefits of a diversified portfolio and wandering into the area where the Bear Market poses the greatest threat -- high price-to-earning ratio (growth) stocks. Only Greg, the least convinced of the three, was shaken by a 10% decline in stocks during a single week in May 2001. He stayed in the field after being chastised by the leader, Heather. She seemed to be proven right when stocks recovered during June and the group's portfolio was up by a large amount for the year.

Then weird things started to happen. Productivity, which had been steadily improving since the early 1990s, began to level off. Signs of inflation began showing up. The growth of the Internet and computer sectors started to creep downward, into single digits. And for the first time in a decade, Microsoft announced earnings below expectations. For the year 2001, stocks in general were down by 9% -- their first decline in seven years.

Our intrepid trio still held fast to their belief that these were natural occurrences and that the Bear Market did not really exist. However, in May 2002, the Fed raised interest rates for the third time in less than a year, and the market fell another 8%. Moreover, although stocks as a whole were down 17%, our heroes' portfolio had fallen by 24%.

At this point, Greg disappeared. No one knows where he went, but remnants of his brokerage statements were found near a bank selling certificates of deposit.

Brian and Heather, although shaken by Greg's disappearance, vowed to continue on. But the market free fall did not stop. In November, economic figures showed that inflation was on the rise while employment was falling. Major companies announced layoffs, and consumer confidence fell to its lowest level in 20 years. By the end of the year their stocks had fallen an aggregate 38%, and Brian and Heather has lost 52%.

Heather lost track of Brian and was forced to weather the storm alone. In an emotional note to her family, she apologized for losing so much of their money. Then, although there were some signs of stability from international and basic manufacturing stocks, Heather stopped accessing her online portfolio tracker. In the end, she had lost nearly 60%, and, apparently, her will to continue.

***

Back to 1999.

O.K., so that was a bit melodramatic. But my concern is that many investors are substantially underestimating the potential volatility of the stock market. Moreover, they are increasing their risk by taking large positions in particular sectors. Some investors may be unaware of how far a market can drop (to see an example, visit our "Bear's Cave") while others may feel that risks are lower in today's market. Well, everyone is entitled to his or her opinion, but I see no evidence that stocks are any more stable now than they were in the 1970s.

I am not literally predicting that there will be a huge market downturn in the next few years. Nor am I suggesting that investors should get out of the stock market -- in fact, all of my money is in equities. However, it is vital to be broadly diversified across various sectors, and to be aware of the risks you are taking. The problem with underestimating stock market volatility is that a sustained downward move for which you are not prepared could cause you to pull out of stocks at the worst possible time -- the bottom of the market.

Now if you'll excuse me, I've got to get back to work on my column based on "Boogie Nights."

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.