Brave Bear’s Edge: Knowing When to Get Out

In the postwar era, common stocks have been uncommonly good investments. From January, 1946, through June, 1991, the Dow Jones industrial average rose at an 11.4% annual rate, compounded quarterly and including the reinvestment of dividends, but with no deductions for taxes.

In other words, $1 invested soon after World War II was worth $114.50 by June, 1991, as shown in Line 1 of the accompanying table. With the consumer price index rising at a 4.4% annual rate during the same period, the real, or inflation-adjusted total return, was 6.7% on average--far better than the historical real 2% to 3% interest rate on long-term Treasury bonds, for example.

Performance this good might suggest that the best investment policy is simply to buy high-quality stocks and then sit back and relax. This outlook is buoyed by Line 2 of the table. The investor who tried to time the market and missed the 50 strongest months would find that this total return was only a 4.2% annual gain.

Don’t rush to the conclusion, though, that like honesty, being fully invested is the best policy; the fact is, being out of the market--or better yet, going short by betting that stocks will fall--can boost returns well beyond the buy-and-hold strategy. An investor who was lucky enough to miss the 50 weakest months in the postwar era (and was in Treasury bills during those months) would find his initial dollar worth $3,185.28 times the fully-invested-all-times return (Line 3).

Why this vast improvement in return? It’s simple: If a stock drops 50% in price, a 50% rise will not recapture its lost value--it must double to return to its former price. By avoiding the 50 weakest months, the investor would have much more money to invest in the remaining time.

The benefit of being out of stocks during the weak periods is even more powerfully shown in Line 4 of the table. There I assume that the portfolio was out of stocks and in Treasury bills in both the 50 weakest and 50 strongest months of the postwar era. As shown, the average return was 12.1%--exceeding the 11.4% return in a portfolio that was fully invested all the time! Missing the weak months is more important than being invested during the strong ones.

The returns are even more extraordinary if the investor was brave enough to short stocks, as shown in Lines 5, 6 and 7. (In a short sale, an investor sells borrowed stock and buys it back later, hopefully at a lower price.) If my investor was out of the market during the 50 strongest months of the postwar era and short the Dow during the 50 weakest, as Line 5 indicates, $1 turned into $2,663, a 19.3% compound annual gain, compared to the 11.4% annual gain in Line 1.

Taking it one step further, if he was short the Dow not only in the 50 weakest months, but in the 50 strongest months as well--exactly the wrong action in the strongest months--his short position in the 50 weakest was so beneficial that he had a 10.6% annual gain (Line 6), almost as rewarding as the perpetual bull (Line 1)! An investor can make a lot of bearish mistakes and still have excellent performance.

The best results would obviously be achieved in the portfolio that was long or fully invested in the 50 strongest months and short in the 50 weakest: Each dollar invested in the Dow in January, 1946, grew to $53,640 in June, 1991, a 27.6% annualized gain. Wow!

The moral of this exercise is clear. It’s profitable to be in stocks during bull markets, but it’s even more profitable to short stocks, or at least be out of the market during bear markets--even if many bull market months are missed completely.

This was exactly the case in 1987 when some savvy investors sold out in the spring when stocks looked overpriced. The Dow spurted another 500 points, but with the October crash, those investors were way ahead of the buy-and-hold crowd for the total year. Why, then, is there so much emphasis by Wall Street and investors on being long and usually fully invested, and almost no interest in shorts or even heavy cash positions?

For one thing, Americans are optimistic people, accustomed to growth--including a stock market that rises over time. Bull markets also tend to accompany boom times with rising employment.

Investment bankers, who generate big money for Wall Street firms and therefore tend to have powerful voices, disdain negative recommendations on stocks and the overall market, fearing that they may damage investment banking relationships. Indeed, managements of client firms can be brutal on those who dislike their businesses and their securities, as those of us previously employed by various Wall Street firms can attest.

Finally, most professional portfolio managers are prohibited from selling short by their clients. They also get nervous over holding large amounts of cash, worrying that their clients will wonder why they are paying management fees if all the portfolio manager does is roll over Treasury bills.

Most investors don’t believe that they can successfully time their exits and entrances in the stock market. But although timing the ups and downs of individual stocks and the overall market is certainly difficult, the investor who is willing to short the stock market, or at least be out of it in times of decline, can make a lot of mistakes at other times and still have superior portfolio performance. And since so few investors are even willing to be anything but bullish, those brave, bearish souls have a big advantage during market declines.

Bulls and Bears

The return on $1 invested in the stock market, as measured by the Dow industrial average, from January, 1946, through June, 1991, through various investment schemes. The simulations show that it’s profitable to be in stocks during bull markets, but more lucrative to bet on a market downturn or be out of stocks during bear markets.

50 Strongest 50 Weakest All Other Avg. Annual Line Months Months Months Appreciation Return 1 *Long Long Long $114.5 11.4% 2 **Out Long Long $ 4.7 4.2% 3 Long Out Long $3,185.0 19.9% 4 Out Out Long $158.0 12.1% 5 Out ***Short Long $2,663.0 19.3% 6 Short Short Long $85.0 10.6% 7 Long Short Long $53,640.0 27.6%

* Holding or buying stocks. ** Not invested. *** Selling borrowed stock and buying it back later betting the price will fall. Source: A. Gary Shilling & Co.