Third time unlucky

Although we are not officially there yet, it appears we are headed into our third bear market in this century. As of the close of trading on Friday, Sept. 23, the S&P/TSX Composite Index was at 11,462.87, down 19.7 per cent from its peak for the year of 14,270.53, reached on April 5.

While there is no universally accepted definition for a bear market, it is generally viewed as a decline of more than 20 per cent from the previous one-year high. A narrower description is a 20 per cent drop in less than two months.

No matter what technical parameters you want to apply, this looks and feels like the real thing. To my mind, the question is not whether we are in a bear phase but rather how deep it will be and how long it will last.

The trends are not encouraging. I am not a technical analyst but when I look at a chart that shows the peak of each rally to be lower than the previous one I know we’re in trouble.

That’s exactly what we’re seeing in the TSX. After the April 5 high, the index dropped sharply and then rallied back to 13,972.02 on April 21. After another sell-off, there was a bounce to 13,829.66 on May 30. That was followed by another slump and then a rebound to 13,494.63 on July 22. After several triple-digit declines in early August, we saw one more recovery to 12,768.70 on Aug. 31. The pattern is clear — each rally peters out before the index can reach its earlier high.

It’s the same story with the Dow Jones Industrial Average. It hasn’t fared quite as badly as the TSX so far because it has a very low commodity component. But after Friday’s close of 10,771.48 the Dow is off 15.9 per cent from its April 29 high of 12,810.54 and the pattern is the same as that of the TSX: each rally high is lower than the previous one.

Except for Great Britain, the major European markets are already firmly in bear territory. As of the close of trading on Friday, the German Dow was off 26.9 per cent for 2011 while France’s CAC 40 Index had dropped 26.1 per cent. Hong Kong was also there at -23.3 per cent as was Brazil at -23.1 per cent.

That brings me to the first of the two key questions now facing us: how deep can it go? If recent history is any guide, we could see the TSX fall to the 7,000 to 7,500 range before the bear goes back into hibernation. Using the interactive charts on the Yahoo! Finance website, I found that during the high-tech crash that opened this century, the TSX fell from 11,388.82 at the end of the week of Aug. 28, 2000 to 5,935.33 for the week of Sept. 30, 2002. That was a drop of 47.9 per cent. In the 2008-09 credit crisis, the Composite fell from 14,984.20 in the week of May 12, 2008 to 7,591.47 in the week of March 2, 2009, a loss of 49.3 per cent.

The hope is that it won’t be even worse this time around. I could not find numbers for the TSX during the Great Depression but between Sept. 29, 1929 and July 8, 1932 the Dow plunged from 381.17 to 41.22, a mind-boggling collapse of 89.2 per cent. If financiers were indeed jumping out of skyscraper windows as legend tells us, it’s easy to understand why.

How long will it last? Well, the Crash of 1929 didn’t really end for almost three years, if we look at the full time span from the high to the low. The Dow did not regain its 1929 high until November 1954, more than 25 years later.

The recovery from the high-tech crash did not take as long, with the Dow regaining its August 2000 level in January 2006 — slightly more than five years later. However, we still have not reached the level attained prior to the 2008-09 meltdown. So it could be argued that we are still in the bear market that began in the late spring of that year which means three years plus and counting.

There’s always the hope that a sudden spurt of inspired political and financial leadership will somehow pull us out of the quicksand. But it looks like a long shot at this point. A recent comment made by Mohamed El-Erian, CEO of PIMCO, was right on target: “We need a conductor. If we don’t get that conductor, it is going to be a very messy orchestra.”

What to do? For starters, I would not recommend holding any equity-based index funds or ETFs at this time. If we are heading for a rerun of the two earlier market plunges in this century, ETFs are in for even more losses. At least the managers of actively-managed equity funds can retreat to cash and/or defensive stocks to provide some protection to unit holders.

Next, be very selective in adding new stocks to your portfolio. There is money to be made even in bear markets but you have to choose carefully and watch for bargain entry points.

Third, to repeat the advice I’ve been giving since last June, shore up your bond holdings. The DEX Universe Bond Index is up more than 8 per cent this year and still climbing. With yields already so low, there doesn’t appear to be any capital gains potential left but people have been saying that for months and look what has happened.

Finally, pay down debt. If we are heading into a recession/depression, the less your debt burden, the better. Even though most borrowing rates are very low (credit cards excepted), repayments have to be made out of after-tax dollars which adds unseen and often unrecognized costs to debt servicing.

As I have said before, I hope things won’t be as bad as I fear. But we need to be ready to deal with a worst-case scenario, at least to the extent we can.

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