Whether or not the U.S. stock market is in bear territory now is really just a technical question for the academics. Investors who have experienced double-digit losses in the domestic equity markets over the last year or so certainly feel like it's a bear market. But how you describe this downturn is far less important than these two questions:

1) How will the next market cycle be described?
2) What can you do to take maximum advantage of that cycle?

The first question is virtually impossible to answer, and any attempt to do so would be a guess more than a definitive answer. But with a little historical perspective and a dash of common sense, the second question can most surely be answered.

To set the stage, we can use the most recent bear market—April 2000 through September 2002—as an example. Large-cap stocks represented by the Russell 1000 Index were down 44% over that period, while small-cap stocks were off more than 30%. Notably, the heaviest losses of that period came in the last 12 months as a sense of capitulation from the average investor flooded through the market. This pattern is relatively common during bear markets that stretch out over several years. As is typical of bear markets, the value-style indices sharply outperformed, with both the Russell Midcap Value Index and the Russell 2000 Value Index actually having positive returns for the period.

This bear cycle lasted a total of 10 quarters, and the intensely negative sentiment associated with growth stocks, particularly those associated with the momentum style of the tech boom, induced many investors to abandon the growth segments altogether. But, predictably enough, when the market did finally turn in the final quarter of 2002, it was those same worn-out growth issues that led the way, with the Russell 2000 Growth Index producing a total return of 60% over the next five quarters. Remarkably, the greatest returns were not realized by the modest growth companies, but by those with the best growth prospects even if the company in question had no current earnings and a heavily indebted balance sheet. Those were the same companies that were punished in the preceding three years.

Of course, this is only one example. Each market cycle has its own unique features. But we think the message is strong enough to be broadly applicable. Specifically, the hardest-hit market segments of extended bear markets are often the very ones that lead the recovery. This seems particularly valid when return disparities are at their widest. Of course, we're still left with the very real question of determining when the market begins its turnaround. Unfortunately this can only be answered months, maybe even quarters, after the fact. Just recall how the previous bear market appeared to be over in late 2001 after the indices shot up more than 20% in the year's final quarter, stayed positive in the first quarter of 2002, then tanked some 30% over the next six months.

So, given the near-impossibility of identifying the bottom of the market; or predicting with accuracy which market segments are going to lead the bull-market recovery; or knowing if history will repeat itself—how should advisors and investors best prepare their portfolios? Our advice is fairly straightforward: Remain confident in a risk-appropriate asset allocation, remain fully invested and remain focused on long-term goals. We recognize, of course, that sticking with a strategic plan in the face of short-term market fluctuations is often not easy, but it can be done.

Manager Spotlight: Riverbridge Partners Small Cap Growth

The Small Cap Growth portfolio from Riverbridge Partners uses a flexible approach to investing, and defines risk within the portfolio as the potential to lose money on any given investment. This creates a conservative growth portfolio that can tilt even more so during periods of market turmoil. Still, the portfolio has managed to keep pace with the Russell 2000 Index during outsized years like 2003—producing a 47% return that year, right at the median for small-cap growth managers and about one percentage point behind the index.
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Riverbridge's investment process is unusual in that it does not rely on quantitative screening to generate new ideas. Rather, the five members of the investment team originate winning ideas through industry contacts, trade shows and industry publications. Once a new idea has been identified, an analyst begins a research process that includes interviews with company management, suppliers and clients, as well as any current third-party analysis. A unique feature of the Riverbridge process is that for each new position, a second analyst is assigned to conduct an independent review of the company and act as "devil's advocate" in team discussions around any further purchases or sales of the security. The portfolio usually has 45 to 60 securities and turnover averages less than 25% per year. The team keeps the focus of the portfolio on true small-cap companies by automatically selling any security whose market cap exceeds $3 billion.