Focusing on these four market conditions helps you make the key decisions having the most impact on your portfolio—the asset allocation decisions. The four conditions are a framework for guiding your behavior and keeping your brain from leading you astray. What's most important about your forecast is getting market direction right, not magnitude. (That's really hard for most investors to get.) Why? Because getting the market scenario right keeps you on the right side of the market. Note: If I forecast up-a-lot, up-a-little, or yes, even down-a-little, I'm going to be 100 percent in equities. It doesn't matter if you think the market will return 8 percent or 88 percent. Either way your asset allocation decision is equities. Yes, your sector weights might be impacted by an up-a-lot versus an up-a-little forecast, but even if you get all of that wrong, and still make the right decision to be in the market, you will enjoy the return you get from getting the asset allocation right. This is all about getting the horse before the cart and not vice versa.

You may rebel at remaining fully exposed to stocks in expectation of a down-a-little year. Should you try to avoid downside by shifting to cash? Only if you're really confident (and not overconfident) you know things others don't. Otherwise you're too likely wrong for what is only a little benefit. Trying to avoid a down-a-little year is the perfect example of a brain overcome by overconfidence. Even if you expect down-a-little, you should focus on relative return. Beating the market is beating the market, even if your absolute return is negative. If you think the market will be down-a-little, ask Question Three. First, you're suffering from myopic loss aversion and you should accumulate some regret. Second, recall you may be wrong and the market might be up-a-little or a lot instead. The difference between up 5 percent and down 5 percent in a year can be just a psychological wiggle toward year-end based on serendipity. But even if you're right, and the market is down-a-little, the transaction fees you incur selling your stocks or funds, ensuing tax bills on your gains, and inherent timing errors outing and inning can seriously reduce any benefit you might gain by skipping a negative 5 percent move.

Then ask, if you get out, will you know when to get back in? Will you time it right? Probably not and certainly not perfectly! If you're really looking for market-like returns, remember the long-term market average includes negative years, and your long-term return isn't much harmed by small negative years. If the market is down 7 percent and your portfolio is down 5 percent there is nothing terrible about that, and in the long run won't keep you from your goals. Renew your faith in Capitalism. Grit your teeth and know better times are ahead.

Investors think they would like a portfolio that's up when the market is down, but a portfolio like that likely lags when the market is up—a more important and higher percentage of the time. If the market is positive more often than negative (which it is), and you have a portfolio running counter to the market, or cutting off the downside at the expense of upside, you won't average out to be happy.

Recall always—when you go to cash you adopt massive benchmark risk. You become completely unlike your benchmark. And just think what happens if you're really, really wrong and there is a "melt-up." You incurred transaction costs, paid taxes, and lost maybe 25 percent relatively or more which comes to about 1 percent a year over the next 25 years—very hard to make up. This is exactly what people do at the bottom of major bear markets when they choose to remain out so they can wait, "for things to become clearer." In exchange for avoiding a down-a-little possibility, they forsake an up-a-lot market.

As for the fourth scenario, the down-a-lot scenario, it's the only time—the ONLY TIME—to take on massive benchmark risk by going to cash or another defensive posture. Your goal here is to combine defensiveness with wang dang doodling TGH by a lot. It's the only time you should ever try to beat the market by a lot. Then, and only then, should you focus more on absolute return instead of relative return—but if you're right you get relative return too, at no extra cost. If you think the market will be down big time, 20 percent or more—maybe 35 percent, 40 percent, or even 50 percent—then you want to get safe single-digit cash or bond-like returns. Getting a 5 percent cash return doesn't sound like much, but if the market is down-a-lot, you have blown the market away on a relative basis.

This should be rare and only prompted by something you know that most others don't. It shouldn't be done by gut feel, by fear, or by your neighbor's opinion. The Three Questions should do it. And the benefits can be huge. If for 30 years, you simply invested in a passive index fund, but once in those years you sidestepped a 25 percent drop while getting a 5 percent cash return—over the 30 years, you would do 1 percent per year better than the market. In the process, you would have beaten more than 90 percent of all professional investors based on only one correct bet. Getting defensive successfully, even if you don't do it perfectly, can provide you with a major and lasting performance boost.

At a bull market peak, there is endless advice saying you should never turn bearish and you should never "time the market," and that people who do are destined to miss the big returns of bull markets. In 2000, this advice was rampant. The financial services industry marketed heavily that any professional who turned bearish was a quack or a charlatan. That advice is simply TGH sucking you into the bear market as it moves disorderly down a path few will fathom. Make no mistake; the rewards from occasionally seeing a bear market correctly are big enough to justify building your bear market muscle—knowing you use it exceptionally rarely.

After bear markets, the heroes are those who did "time the market" and turned bearish. Many of them will have been bearish way too early—often for years before the bull market peak—having been a "perma bear" (stopped clocks with miserable returns, but short-term media heroes nonetheless).

Alternately villainizing then making heroes of those who went defensive is TGH at his finest as he teases investors' brains to keep looking backward instead of forward.

At the end of every bear market, the media canonizes those who were bearish as it began. At the end of every bear market, timing services become more popular—just when you won't need them for years. This happens every time. The key is to keep the bear market timing skill for long periods of time when it's never used—dry powder for the rare day you need it.

I've only turned defensive three times—mid-1987, mid-1990, and late 2000. I was very lucky each time. The next time I'll probably screw it up. (Reminding myself of that is one way of reducing overconfidence.) Avoiding a big slice of those bear markets is a huge piece of what built my career. When you avoid a slice of a full-fledged bear market you simply buy years of excess return. If you went into the bull market peak slightly lagging the market, one successful by-pass of a bear market catches you up and moves you ahead. It's hard keeping a skill set honed and available you use only a few times in your investing life. Most folks won't, which is why you should. They want to hone the skills they use daily, not once a decade.

Many get all this very wrong. It's 2000! My firm and I turn bearish and generate cash and cash equivalents for clients. The market falls. It's going exceedingly well. Every year we take on new clients. Making that call well pulls clients in droves. Some clients join my firm in the year before we re-enter the market. They're sitting in cash. Some clients join just weeks before we re-enter the market. They're sitting in cash. As mentioned earlier, we re-entered the market too early in 2002 and portfolios fell with the market. Some of these clients stayed on. Some terminated our services. Those terminating our services thought we lost them money. Think it through. Neither my firm nor I ever claimed to have perfect market timing capability. If we did, we would own the world fast. If you were a client when we turned bearish, we put some distance on the market as just discussed, doing so without perfect market timing, yet helping get to the long-term goal. If you became a client just before we re-entered the market too early, we still didn't keep you from your long-term goal: to get equity-like returns and try over some long period to do a little better than the market. But those terminating at that point thinking, "You lost us money," shifted their benchmark to a myopic focus on the short-term that doesn't serve them in the long-term. They missed 2003—a whopping big year, erasing losses and more as 2004 and 2005 continued with positive returns. Those folks inning-and-outing in 2002 simply missed all that. This is TGH at its finest—getting people to get out at the worst time and never really understand what happened to them. If they asked Question Three it could have helped them a lot.

Never forget how fast the market moves. Your annual return can come from just a few days of big moves (as you can see illustrated in the table). Do you know which days those will be? I sure don't and I've been managing money professionally for over a third of a century. No one knows what the market will do in the next or any other few days. No one can tell you which 3, 6, or 9 days this year render the bulk of your gain or decline. If you want to get market-like returns, you must hang in there with the market. Look at 2005. Though most major indexes were positive (except that dirty Dow) it was an unimpressive year. The world market, via the MSCI World Index, was up 9.5 percent.^[152] The S&P 500 was up less than 5 percent.^[153] Not rip-roaring! At the end of 2005 the media was predictably glum. Many investors decided they'd had it with this go-nowhere market. So, the world market rose 4 percent the first two weeks of January 2006.^[154] In just two weeks, the market did half of what it did the entire prior year! Investors who were fatigued from a flat year and bailed on the market missed what they had waited for. TGH was lying in wait for them, and their Stone-Age brains played right into it. Stopping to ask Question Three can alleviate many cognitive errors induced by market fatigue.

HOW TO BUILD A DEFENSIVE PORTFOLIO

You've used your Three Questions and are confident the most likely market scenario over the next year (or so) is down-a-lot—a true bear market. But what do you do? What should a defensive portfolio look like? It depends. You hate hearing that, I know, but it's true. Different bears are different. In some bear markets, some sectors survive swimmingly, but you won't know which until it is on you and maybe not then.

In bear markets, you're safest in a mostly cash portfolio. Liquidity is key—markets move fast as bull markets begin so you need to be prepared to get back in. If you're illiquid or you ease your way back into the market, you're likely to miss the big bang off the bottom. use money markets and short-term government bills. You don't want to buy anything with a long maturity unless it can be sold instantly. You don't want bank CDs that hold you hostage for a specified period because when the time comes to get back in, you don't want to be held back. Be defensive but liquid.

Market Neutral

During the 2000 to 2002 bear market, I wanted a portfolio that acted cash-like but with better than cash returns. I wanted to be immunized against downside volatility and to be very liquid, so I could quickly get back into the market when needed. I wanted tax efficiency. And I wanted to take advantage of knowing something others didn't by overweighting certain sectors and underweighting others. Since I expected tech to be weak and had dedicated significant resources to that call, I wanted to get some juice from it. To do that I had to be market neutral—own equities with sector exposure but no net exposure to owning equities. What does that mean?

I created what I called a "synthetic cash" portfolio encompassing all those goals. My asset allocation during that time added up to 130 percent of my real portfolio. Here's how:

• First, I had 30 percent in huge, blue-chip, defensive European and U.S. stocks—big drugs, banks, and consumer staples. Anything that was considered "defensive," so cyclicals were out. I wanted companies with inelastic demand for their products, not elastic, since during bear markets folks tend to dial back their spending. A lot of these were super-cap stocks bought in the late 1990s with capital gains I didn't have to realize because I didn't have to sell them. Effectively, you can think of it this way. When the time comes to create synthetic cash, sell what you can that doesn't involve a capital gain, and then do the index-shorting (mentioned shortly) to ensure you don't lose capital from the bear market decline.

• Next, I had about 38 percent in liquid U.S. Government Bonds (not too risky).

• I had 2 percent in index puts against the S&P 500. I bought puts expiring about a year out. Index puts are a classic dream—they're relatively cheap insurance with relatively low premiums at the right time (market tops), and very expensive insurance at the wrong times (market bottoms). Index puts are just like casualty insurance where the casualty is the index dropping big. The puts would pay off handsomely if that happened and simply expire worthless if it didn't. I had little to lose with such a small position. A two percent loss, if they didn't pay off, would largely be covered by my bond income. But the portfolio would get considerable juice if the bet paid off. Every time the stocks sagged the puts soared in value.

• Then with 30 percent I sold short the Nasdaq 100 and the Russell 2000 (20 percent and 10 percent respectively), took the proceeds and held it in cash—another 30 percent. (30 percent + 38 percent + 2 percent + 30 percent + 30 percent = 130 percent. That's how I reached 130 percent.) Those of you who are individual investors probably don't have enough leverage versus your broker for them to give you the cash when you sell short and there is nothing I can do to help you overcome that. My bet was the combination of the Nasdaq and Russell would drop more than the stocks I held. So I borrowed the indexes and sold them short with the hope when they dropped, I could buy them back at a lower price and the difference was all profit—and bigger than the losses I had on my stocks that fell. Instead of reinvesting the proceeds from shorting the indexes, I held the cash in the event I was wrong. But even the cash earned income.

  Hypothetical Defensive Portfolio Allocation

This time I wasn't wrong, and the market fell a lot during those bear market years. This portfolio fared very well in those conditions. The Nasdaq 100 short did a lot better than the Russell 2000 but together they worked just fine, rising in value as the stocks I held fell. I don't know how I'll construct my next bear market portfolio, but next time, based on the conditions then, we'll try to create contemporary synthetic cash that is nonvolatile, liquid, tax-efficient, and still allows for some stock and sector picking.

As that column said, I'm hesitant to use the word "bubble" since it's bandied about so much by so many who understand bubbles so little. As I write this in 2006, the world has anticipated a residential real estate bubble bursting for four years. Not only all over America, but they anxiously await it in London, Paris, and much of the Continent. For four years! Why won't it burst, darn it? Manhattan-based journalists renting overpriced railroad flats are waiting in gleeful anticipation to dance and chant, "I told you so! I told you so!" Stopped clocks! At any rate, real bubbles are few and far between. Applying the word "bubble" should never be done lightly.

A little noted point about the supposed residential real estate bubble: In the history of the world, there has never—not ever—been a bubble widely called a bubble before it burst. Before they burst, real bubbles are widely seen as a new paradigm, a new era, fundamentally different from the past, where the old rules no longer apply, where you get great returns with little or no risk because it's different now. Before Japan's bubble started bursting in 1990, they were seen as superior businessmen with whom the West couldn't compete. When tech was a bubble it was, "The New Economy, Stupid." But when something is called a bubble that hasn't actually burst yet, it means the price has gone up a lot, as happened with residential real estate, and a lot of people fear it will go back down. (This is our heights framework again.) That fear is already in the market and taken a lot of risk by its mere presence.

When something is really a bubble, it isn't called a bubble and people don't fear it. In the years 1997, 1998, and 1999, there was no national press coverage of tech as a bubble. Tony Perkins wrote a book late in 1999 describing Internet stocks as a bubble but it didn't sell well. My Forbes column calling tech a bubble was one of the first appearances of that word in national print associated with tech. If everyone recognizes something as a likely bubble, it isn't one. But what I saw in early 2000 was eerily similar to what I had witnessed and later measured without having actually forecasted it in the energy sector in 1980—a real bubble with the potential to start a rippling, fierce, sector-led bear market.

Think back to 1980 and how unstoppable the energy sector seemed. Thanks to 1970s global central bank gross monetary mismanagement, inflation was soaring and commodities booming. OPEC was powerful while the Iran-Iraq War was raging. Oil was $33 a barrel and the consensus was forecasting $100 a barrel in four years. No one was calling for oil prices to fall. Just so, in early 2000, the consensus foresaw Internet users tripling globally in four years, and most folks, not just the dingbats at BusinessWeek, were heralding "The New Economy." Earnings don't matter. It's a new paradigm. Its clicks, not bricks! You remember.

There were abundant energy to tech parallels—in the rapid growth of the sector, the number of IPOs being foisted on the market as a percent of all stocks, swelling supply, and the shallowness of the business models coming to market. In March 2000, the 30 largest U.S. companies represented 49 percent^[156] of the U.S. stock market's value—and half of those were tech stocks. Rewind to 1980, and the 30 largest U.S. stocks made up a third of the U.S. market's value and half of those were energy stocks. Effectively, the equity supply-demand picture for tech looked almost identical to what had happened in 1980 so I could fathom an outcome not dissimilar to 1980's. The relative valuation multiples compared to the whole market for energy in 1980 were similar to those for tech in 2000. Too many parallels—all unnoticed seemingly by anyone. In the box, I detail two such parallels we tracked closely that contributed tremendously to the decision to bail on tech.

THE MAKING OF TWO BUBBLES

The 1999 and early 2000 tech IPO explosion reminded me eerily of the 1980 energy bubble that led the whole market into a bear market. I fathomed tech could do the same. Via Question Two, I tried to see how many parallels I could find between the two sectors that no one was commenting on.

Because I know stock prices are determined—always and everywhere—by supply and demand, I started with the notion that a flood of supply might topple prices. The following table demonstrates the rapid increase of stock supply in both of these sectors through respective IPO booms in the late 1970s and late 1990s. In 1980, nearly half of the increase in value of all new and existing U.S. companies came from the energy sector. In 1999, nearly all of the increase came from the technology sector.

The Making of Two Bubbles

Also, note the similarities between the percentages of new tech stocks relative to all new stocks and all U.S. stocks in 1999 to those of 1980's energy bubble. Note also the price-to-book value of each sector relative to the market. Each was trading at roughly twice the market multiple. Who would remember today that in 1980 energy stocks were priced like growth stocks? Scary times. The key is no one saw it or mentioned it.

Now look at the relative weights of these two sectors in the following table. The top three tables show energy relative to the S&P 500 during the bubble and after the crash in 1979, 1980, and 1981, the bottom three show tech during 1998, 1999, and 2000.

A Brief History of Sector Bubbles S&P 500 Economic Sector Weights

Note the similarities between the relative weights of energy and tech. At its 1980 peak, energy was 28 percent of the U.S. market. But tech's explosion was more remarkable—growing from 5 percent in 1992 to just over 30 percent in 1999. The way I saw it, tech had further to fall. But it didn't need to fall much further to create the same major bear market energy created between 1980 and summer of 1982. (Today, tech makes up 15 percent of the U.S. market as measured by the S&P 500.)^[157] Both of these observations weighed heavily in my decision to call a peak in the tech market in 2000.

In some ways, I could fathom tech being worse than the oil bubble. In 1980, none of the 50 largest energy stocks were an IPO of just a few years before, say 1978 or 1979. The 1978 to 1980 IPOs, though many, were smaller. In 2000, 11 of the 50 largest stocks were IPOs in 1998 and 1999. That increased risk. Most unsettling was no one noticed the parallels between the tech fervor and the last sector bubble 20 years earlier. I wasn't the only financial practitioner to have witnessed the energy crash—by any means. I wasn't the world's only person with access to the data for comparison. There were lots of folks who should have seen this before me. But I couldn't see them seeing it anywhere, which was scary. Around the campfire, they were peering a different direction.

Was I certain tech would implode and the market drop? No, but it was logical. First, all the ugly parallels to 1980 were invisible to everyone. Second, you had to wonder who was left to buy who hadn't done so? Who was left as fresh fodder for TGH? Based on sentiment, the yield curve, the budget surpluses, equity-based takeovers, and oil parallels I was content to eliminate possibilities of an up-a-lot or up-a-little scenario. Then again, down-a-lot seemed unlikely too. As I knew from looking at 1981, it took a long time for the oil meltdown to ripple out through other sectors. A sector bubble bursting doesn't ripple to other sectors fast. So my presumption was tech would start down and be down-a-lot. But it would take time to drag down the rest of the market. So, for a major market meltdown we would be waiting longer. Finally, I knew bull markets die with a whimper, not with a bang. Basic rule! Normally bull markets don't have a dramatic spiking top, but roll over slowly. Around the 2000 peak there was over a 10-month period where the world stock market never got out of a 9 percent bandwidth (see Figure 8.2).

As 2000 faded, with the Nasdaq down 39 percent and the S&P 500 down 9 percent for the year^[158] and investors and professional forecasters still bullish, I finally concluded the time was nigh to turn fully bearish. Not just bearish to tech but overall bearish. By then the tech bubble bursting was in process. Additionally, I could see new tech companies were burning feverishly through their cash, just as new energy companies had in 1980—almost identically the same proportions (as I detail in the following box). We could measure how many would run out of cash if they didn't get back to the public market to raise more money—implying either company implosion or yet more new stock supply—either had to be bad looking forward.

Figure 8.2. Bull Markets Die with a Whimper, Not a Bang. Source: Thomson Financial Datastream.

INTERNET BURN RATE

In September of 2000, after the Nasdaq was 16% off its peak and the S&P 500 was at 4% for the year, investors remained generally bullish, though we now know we were headed into a prolonged downturn. An easy way to check sentiment and combat hindsight bias is to review old magazine covers and articles. Sentiment remained widely euphoric.

I had already made my tech bubble market call and my firm had been defensive against tech for nine months. We were considering getting bearish as a whole. Adding to this was research we did on the flood of new companies entering the market during tech's IPO boom.

Many of the new tech stocks relied on capital markets to keep the lights on and computers running. They didn't generate cash themselves, so they turned to investment bankers to keep raising capital for them. (Remember, the investment bankers are happy to do it for the big fees!) These firms relentlessly spent, hoping one day to be bigger than a bubble. The problem was, if they couldn't or didn't raise more money, many of these neophyte dot-commers would simply hit the wall with no more cash and implode. The choices were to sell new stock creating new supply or die. One is bearish; the other is deadly.

Internet Burn Rates

Source: Standard & Poor's Research Insight.

For a gauge, we calculated the burn rate for as many new tech stocks as we could find data. Burn rate measures how fast a firm will run out of cash in the absence of new cash. To measure burn rate, we compared cash and net losses through the second quarter of 2000 (it being September when we last did this). Assuming these firms found no further outside funding, we divided current cash by second quarter net loss to get the burn rate. For example, Wavo Corp (remember them? You don't? Neither do I. They Wavo-ed out of existence), which rung in at number 18, had $4.7 million in cash on June 30, 2000 and a quarterly net loss of $8.9 million. Dividing cash by net income yields a burn rate of 0.54 quarters. This meant wacky Wavo had only one half of one quarter's worth of cash left, assuming they continued to bleed money at the same rate and couldn't pull off an offering of new stock really fast. That's not Wavo. That's Whacko!

In all, we found 223 material publicly traded companies so short on cash that if they didn't pull off a new stock offering very fast they would be a quaint memory. The table shows the 25 worst offenders. In just one quarter, the aggregate market cap of companies fitting this mold jumped from $140 billion to over $312 billion—not from the prices rising, but because so many were increasingly close to hitting the wall and no one was counting. The market was flooding with stock supply from profitless companies. With the IPO market soured, pretty much all these companies were gone 12 months later. The bubble had only just begun to burst.

Putting together this table is pretty straightforward, should you ever want to measure burn rates yourself. All of the information we detailed is publicly available. You just need a fast Internet hook-up and a sector you suspect.

Note that tech started 2000 worth 30 percent of the total S&P 500. If a 30 percent sector is down 39 percent, as Nasdaq was in 2000, and everything else is flat, then the whole market should be down 11.7 percent. But the S&P was only down 9 percent in 2000. So technically the rest of the market—the nontech part—was up a hair. It was true. The sector breakdown hadn't yet rippled out to take down the rest of the market with it.

Nothing had yet changed to alleviate the cash-starved supply flood of tech IPOs and secondaries. I knew supply had finally drowned demand. Dot-com after dot-com quietly ran out of cash. This had to ripple out of being a sector-specific phenomenon—the rest of the global market would price in the supply. If there had been even a little fear in the market about tech or the yield curve or anything, I could have seen the market being down just a little in 2001. When most everyone has no fear is the best time to get really fearful. Repeat after me Mr. Buffett's wonderful mantra: "You should be greedy when others are fearful and fearful when others are greedy." I could fathom at the end of 2000 there simply being no buying pressure in 2001 to keep the market from being down-a-lot.

Often in a bear market, some sector goes bad first. Selling ripples to other sectors in a process I call sympathy selling. It works like this. Suppose you were a generic tech mutual fund. You own little dot-coms and big established tech giants. Out of nowhere, as some of your dot-com holdings implode, you get simultaneous redemptions. You must sell something to get the cash to cover redemptions. What do you sell? You can't sell the little dot-coms getting hammered so badly—they aren't that liquid and you hope they'll bounce back—so you sell your Intel, Microsoft, and Oracle because you can. And that selling hits those stocks. But this is also happening to all the other generic tech funds. But then, some growth stock funds own tech, drug stocks, consumer products companies, and whatever else. As Intel, Microsoft, and Oracle get hit, that fund manager must sell something else to cover his redemptions, so he reaches out and sells Merck and Procter & Gamble. This ripples from fund to fund having the most impact where the process started but eventually rippling far enough to hit, not all, but most of the market. From 2000 to 2003, the only parts of the market that escaped were the small, steep discount value stocks—exactly the reverse of where the damage began with high-end growth tech stocks.

So in 2000, I cut my tech holdings and at the end of the year I got completely defensive, holding 100 percent cash or cash equivalents, and stayed that way for 18 months.

TGH will try fooling you into thinking every bull market is really a bear market in disguise. TGH conspires so a new bull market comes dressed in all the trappings of a "secular bear" market. Bull markets are unabashed cross-dressers. I've never seen a bull market that didn't come to the party wearing a full-on bear suit. Unfortunately, most investors aren't looking for cross-dressers. All they know is, way late into the party, they've been fooled into thinking they've been sharing a few laughs with a bear, and WHAMMO! They've missed out on the first 50 percent up-leg of a bull market because TGH had their minds warped.

Arm yourself against TGH by knowing how to tell a cross-dresser from the real deal—a correction from a bear market. The major differences between the two are magnitude and duration. A correction is a short-term 10 percent to 20 percent scary global downturn. It's short, sharp, and comes from nowhere with a spike top and a fantastic story leading you to believe more downside is ahead. It's over just as fast and rockets higher returning to new highs about as fast as it fell. One to four months down and then back up. Four months later the whacky story that pervaded the downturn sounds silly but at the time it first appears you can't really disprove it.

Table 8.3. Never a Dull Moment

You may think 20 percent, just like mid-1998, is quite a lot and officially qualifies for a bear market, but the operative words here are "short and sharp"—right off the cliff, defying our 2 percent rule. Corrections are common in bull markets (one every year or two on average) and devilishly tough to time—you shouldn't try because they down-and-up so fast. To time these little suckers successfully you must be right on both ends. Odds are you'll miss either a good exit or re-entry point or both. Don't bother. (No one—and I mean no one—in the history of asset management, with all of the tens of thousands of practitioners, has ever made a successful long-term practice of timing short-term downturns. If it were possible, at least one person would have done it by now. But no one has. Ever. And if you could you wouldn't be reading this book.)

Similar to a down-a-little scenario, any benefit you get by being super lucky and accurately timing a correction can get eaten up by transaction costs and taxes. Just sit tight, know you're probably being entertained by a bull in drag, and you'll get your reward for patience.

But a bear market's beginning feels nothing like a correction. It feels fine. A bull market top won't announce itself with a sudden price drop. There is no announcement effect (except 1987, the exception to the rule). Instead of a bull in a bear suit, you get a bear in a bull suit. As stated earlier, bull markets have grinding, rolling, whimpering tops, and a relative absence of bearish sentiment (other than perma-bears). You won't hear a bang. You won't "feel" like you are about to experience a prolonged downturn. In fact, you might "feel" like your diversified portfolio is boring and you should place big bets on individual stocks or spectacular sectors to boost returns.

Historically, if markets have been positive 71 percent of the time,^[161] and some of those negative years were only down-a-little, you're looking at very few years of the truly scary, bearish, down-a-lot type. Since 1980 there have only been four^[162] so you shouldn't expect to see them too often. The future shouldn't be too different. Another way to see this is, if you're bearish much more than 3 or 4 times in two decades, you're overdoing it. Recall as human beings, we normally exert more effort to avoid pain than achieve gain. Remember that. If your brain keeps telling you a bear is always impending, your brain is wrong. Successful bearishness requires being virtually alone. You must act alone, without others. But if you have the Three Questions you're never really alone.

Some of you may say, "But we live in a different world now. A terrorist attack would break the market, right?" That's a fair question. The tragic attacks on September 11, 2001, came two-thirds of the way through a material preexisting bear market and a recession—possibly stalling off market resurgence (though we have no way to measure if that's true or not). So pull a Question One. Is it true September 11 had a lasting, devastating impact on the market (see Figure 8.6a)?

The U.S. stock market closed that day and stayed closed until September 17 when trading resumed—Wall Street's inhabitants scattered to the winds. The S&P 500 nosedived when the market opened—down 11.6 percent by September 21.^[163] But amazingly, in only 19 days the U.S. market was trading above September 10 levels. And it remained above those levels for months. We remember this differently because long before the attack the global economy was in a recession and bear market. Did the attack exacerbate the situation? Maybe! But reread this paragraph and repeat after me: "Back to where it was only 19 days later and then higher for months." Note the higher period included all those fears in the fall of 2001 about anthrax. Remember anthrax? The market moved higher right through it without interruption, lifting to prices steadily higher than on September 10. Let's delve further, think globally (as always), and see how the more recent terrorist attacks on Western nations have impacted the stock market (see Figure 8.6b).

Figure 8.6. Have No Fear: The Market Doesn't. Source: Thomson Financial Datastream.

On March 10, 2004, more Al Qaeda goons took credit for a massive train bombing in Madrid. The Spanish referred to the event as "Our 9/11." In other words, this "surprise" was a devastating national tragedy. And yet, the S&P 500 dropped 1.5 percent that day and traded at pre-attack levels a scant five trading sessions later.

On July 7, 2005, they bombed the London Underground (see Figure 8.6c), not far from where some of my firm's employees work and live. Yes, we worried until our London counterparts were confirmed safe. But the market was downright callous about their well-being. The S&P 500 was positive that day. The market was indifferent to the attack. Terrorists lost that battle.

Terrorism has since continued, mostly isolated to the Middle East and Africa. Then, on August 10, 2006, well after I'd rough-drafted this book, a group attempted to construct liquid-based bombs for 11 London wide-bodied flights bound for America. They were apprehended. The aftermath was another ratcheting-up of security standards for flights across America and Europe—causing increased flight delays and inconvenience as the new rules for carry-on items were implemented. The market yawned. It dropped a hair the next two days and rallied 3 percent the next week. The market is getting calloused to terrorists.

Whether all future attacks have already been discounted or not is debatable. So far, they haven't been able to pull offa hugely successful attack since 9/11. Recall, these were guys with box cutters in a world where pilots were instructed to take hijackers wherever they wanted to go. But since then, there has been no market panic to terror anywhere. How can investors be so blase about terrorism? This is a new, terrible, and very real threat to us wherever we live, work, travel, and defend ourselves and our friends. Or is it? We have had previous terror attacks here in the U.S. and on U.S. interests. There was the USS Cole bombing in 2000. And Khobar Towers were bombed in 1996. And that first attack on the Twin Towers in 1993. And the attack on the Marine barracks in Lebanon in 1983. And Pan Am Flight 103. And the entire history of Israel. And the Irish Republican Army in Britain. The British lived with terrorism on their soil seemingly forever and their markets did fine then. World War I was sparked by a terrorist act. There were the Barbary pirates and Tripoli. You get what I am saying. Terrorism isn't new, devastating as it is at a human level. But we are resilient, and so are our markets. Figure 8.7 shows a number of terror attacks in recent history, and the time the markets took to recover.

But would a large terror attack now break the market? First, ask if another terrorist attack would surprise you? You may be more surprised—knock on wood—we've yet to experience another major American attack (as of this writing). Put yourself back to September 10, 2001. If someone told you 19 thugs armed only with knives and box cutters would perpetrate a coordinated attack using planes and their inhabitants as bombs, you would have thought it was the plot for a Bruce Willis movie, not reality. That what happened would happen seems unthinkable.

Figure 8.7. Have No Fear: The Market Doesn't—Historical Perspective. Source: Thomson Financial Datastream.

Today there is nothing they could do that would surprise us. Yes, it would be negative, but whatever it is it would have less market impact than you may fear because we've been psychologically preparing for it for five years.