Being Street Smart

Sy Harding

Can Corrections Be Better Than Rallies? February 5, 2010.

Twenty years ago, just prior to the 1990 recession, I wrote a little booklet for my subscribers which I titled ‘Bear Markets Are Best’. Its premise was not that bear markets are really better than bull markets, but that they are not something to be feared, and do have some advantages over bull markets. The same goes for intermediate-term corrections within bull markets.

For instance, if y ou position for them in a reasonably timely manner, not just by moving to cash to avoid losses, but to downside positions that go up when the market goes down, the profits can come faster than they do in rallies and bull markets.

That’s because the market moves down much faster in corrections than it moves up in rallies.

For instance, in the 1990 bear market the S&P 500 lost the gains of the previous 15 months in just four months of decline. An investor playing the downside could have made at least some portion of 15 months of gains in just four months, rather than giving back 15 months of gains. In the 1987 bear market the S&P 500 lost the gains of the previous 18 months in just three months. In the 2000-2002 bear market it lost the previous four years of gains in two and half years. In the recent 2007-2009 bear market it lost its previous five years of gains in just 17 months.

At the present time, since its peak on January 19, just over two weeks ago, the S&P has lost all its gains of the previous three months, closing Thursday at its level of November 5.

It is an important lesson not just for buy and hold investors, but for all investors. When market declines take place, if no action is taken, previous gains can be given back much quicker than they were made. Just avoiding at least some of the decline is advantageous to long-term investing performance. If even partial downside positioning is taken in time, further gains can actually be made from the market decline.

In the ‘old days’ prior to the introduction of bear-type mutual funds, and the more recent introduction of ‘inverse’ mutual funds and ‘inverse’ etf’s, investors could only take advantage of market corrections to avoid large losses, and then make some of the profits all over again by getting back in at lower prices.

Even that strategy produced significant market-beating performances.

In 1986 Norman Fosbach included a study in his book Market Logic covering the period from 1964-1984, in which he found that an investor starting with $100,000 in 1964 would have produced a gain of $775,000 over the 20-year period on a buy and hold basis, using the S&P 500 as the proxy. That’s a substantial gain.

However, his study found that if an investor could have timed only the major market swings over the period he would have turned the $100,000 into $13,810,000 over the same period. And timing only successfully enough to avoid the three worst downturns of that 20-year period would have turned $100,000 into $4,797,000, almost six times as much as the market made on a buy and hold basis.

In fact, Fosbach’s study found that any degree of success at all in avoiding even a portion of downdrafts had a tremendous effect on long-term accumulation of wealth.  His study showed that if one recognized a correction was underway only perceptively enough to sell short for only one-fourth of each of the three worst corrections during the twenty-year period, and remained invested through all the rest of the downturns, he still would have tripled the return of a buy and hold strategy.

I haven’t run the numbers, but given the market’s periodic give-back of previous gains over the last twenty years, which I noted at the top of the column, it seems obvious that it has been the same situation for the last 20 years. Avoiding even a portion of the big losses, or even better, to make additional gains from downside positions during at least portions of big declines, can be a major influence on long-term investing success.

Given the market’s action of the last two weeks it might be something investors would do well to study up on.  

Sy Harding is editor of www.StreetSmartReport.com, and the free daily market blog, www.streetsmartpost.com.