Monday Morning: Was bear market too short to teach a lesson?

Let’s say the Federal Reserve’s rate cut last week halted the bear market. The question is: Now what do we do?

Do we rush back into equities? If so, what equities? Have growth stocks been beaten down enough to make them attractive? Do we invest in value stocks, or have we already missed most of the gains that value stocks are likely to give?

Or do we take the opportunity to lock in whatever gains we have by selling the winners and the obviously hopeless losers, and then retire to the safety of bonds and money market funds?

The questions are especially pointed for financial planners and investment advisers, some of whose clients have found their risk tolerances to be far lower than they originally believed.

Many of those clients allowed their equity exposures to climb uncomfortably high because of the bull-market euphoria that swept the country over the two years through last summer. Now some do indeed want to get out of the market as painlessly as possible and retreat into bonds or cash.

But those questions are premature.

The correct first step is to go back to basics and answer more important questions: What is the primary goal of the investor? What is the investment time horizon? How much risk is the investor really willing and able to accept? (It may now be unrealistically low.)

Only after answering such questions can an investor, with the help of an adviser, decide on an appropriate long-term asset allocation.

As Robert Smith, president and chief executive officer of Smith Affiliated Capital, a New York-based fixed-income manager with more than $800 million under management for institutions and wealthy individuals, said last week: “Too many people lost sight of asset allocation during the bull market.”

Mr. Smith believes more investors – institutions and individuals – will begin to reevaluate their asset allocations and not allow market moves to push them so far away from the right allocation.

The stock market, despite last year’s 9.1% loss, generated five-year compound annual returns of 18.4% and 15-year compound annual returns of 16%. It produced only one other losing year out of 15. That led many investors to believe in all-stock portfolios.

In the environment of the past 15 to 20 years, diversification seemed solely to reduce return.

But properly structured diversification across asset classes can enhance long-term return while reducing risk. And, Mr. Smith argues, proper diversification includes bonds.

Yes, over the past 15 years, long-term corporates returned only 9.4%, and long-term Treasuries returned 10.4%, but when added in appropriate amounts to most portfolios, they would have helped produce far higher risk-adjusted returns than most investors achieved.

Some advisers might be tempted to add foreign stocks to client portfolios for diversification rather than domestic bonds. But, Mr. Smith says, U.S. bonds have outperformed foreign stocks since 1990, providing not only superior returns but also superior diversification.

That may be a period-specific result, but it nevertheless suggests foreign stocks should not crowd bonds out of the asset allocation.

If the bear market has convinced investors of the need for asset allocation and the value of diversification, the pain will have been worth it.

The danger is that the Fed’s rate cut has placed a bottom under stock prices too soon and that the bear market has been too short for the lesson to stick.

Mike Clowes is the editorial director of InvestmentNews.

Related Topics: Just Thinking