How can a 20-year bear market be possible if the market wasn’t overpriced to begin with? Surely it’s only a matter of time until reason is restored and the market returns to its previous level? Sorry, but I think that’s unlikely. As I pointed out in a 2005 article titled Profits won’t defy gravity forever, the P/E argument is naïve.

Yes, the P/E was in line with its long-term average. But corporate profits – the ‘E’ part of the equation – are the highest they’ve ever been when expressed as a percentage of the overall economic pie. All of the forces of capitalism work to bring this ratio back to its average. Shrewd investor Jeremy Grantham’s US research led him to the conclusion that this is ‘one of the most mean-reverting series in finance’. But even if you reject Grantham’s argument, you will, as Warren Buffett put it, ‘get into certain mathematical problems’ if you expect part of the economy to continue growing faster than the whole.

For mine, I’m on board with Grantham. I expect the profitability of corporate Australia to fall, in some cases dramatically. In fact, the process is already under way.

Profits under fire

The first profits we’re seeing disappear are those that were never there to begin with. The fictional profits reported by the likes of Macquarie Airports, Macquarie Infrastructure Group and a litany of property trusts – thanks to asset revaluations – are a thing of the past (thankfully).

Next in line are the financial sector’s profits. This sector’s share of the economy was about 1% in 1960. In 1990, it was still about 1%. But by December 1999 it had doubled to 2%, and in June 2007 financial corporations were generating 3% of the nation’s gross domestic product (GDP).

Cheap credit and soaring asset prices translated into rapid loan book growth and record low default rates (it’s hard to default when they keep giving you more money). Some of the change is related to deregulation and could be permanent. But finance remains a highly cyclical industry and the cycle has most definitely turned.

Perhaps the largest contributor to the wonderful times for corporate Australia, however, was the resources boom. Most resources are not sold domestically. They’re exported, which means that in theory resources sector growth could outstrip domestic growth for a long and sustained period. But, for the moment, commodity prices are in a tailspin. Zinc is off 77% from its 2006 high and copper has fallen 60% since July. Nickel, a tonne of which would have cost you US$54,300 in May 2007, is now changing hands for US$9,800 a tonne.

Those prices are in US dollars and a plunging Australian dollar will shield local miners to some extent, but nowhere near enough to maintain current levels of profitability.

Blue chips expensive

These two sectors, mining and finance, represent roughly 70% of the total Australian market. So when you consider the overall market’s P/E of 10, you need to consider the fact that the low P/Es of these businesses are dragging the average down. And justifiably so, based on the evidence at hand. In fact, as I wrote last week, many blue chips look decidedly expensive next to some of their international peers.

And I’m not particularly confident about the rest of the economy either. In relation to both their assets and their income, households are carrying more debt than at any time in our history. We have a generation (my generation) of consumers and companies that know nothing but good times and easy credit.

Australia is fortunate enough to have a large government surplus and room to move on interest rates. That gives the authorities ammunition to defray some of the pain caused by falling house prices and tight credit, but it doesn’t change the fact that spending more than you earn is an unsustainable practice. An adjustment to a sustainable level of consumption needs to take place and it won’t be pleasant for those businesses, particularly retailers, that have grown fat on the profligacy of the consumer.

In short, while substantially lower share prices compensate for much of the doom and gloom, we remain concerned about the state of corporate Australia. In many cases share prices still don’t seem to compensate today’s investor adequately for the risks they’re taking on.

That, in a nutshell, is why I think you should prepare for a long and protracted bear market. Don’t be fooled into thinking things can’t get any worse.

Making money in a bear market

My strategy for dealing with this scenario is not complicated. First, avoid potential disasters – no matter how enticing the potential returns on offer. Mr Market, a fictional character first invented by value investing’s godfather Ben Graham to describe the stock market’s bipolar personality, is in a foul mood. He’s short-tempered, quick to anger and impatient, and this is no time to be asking him for favours (just ask GPT shareholders who have seen their stakes in this iconic group severely diluted by a forced capital-raising at $0.60 per unit). Stick to businesses that don’t need any favours from anyone and avoid those that need to refinance debt or raise equity.

Second, find stocks that will deliver their value to you in cash. If you hold such stocks, the length of the bear market won’t make the slightest bit of difference. Take, for example, electronic-parts-catalogue manufacturer Infomedia. This business sells essential software subscriptions to the automotive industry and generated $13m in profit last year. It consistently pays 80% of its profit out as fully franked dividends, equating to a yield of more than 8%. The company has $14m of cash (as at 30 June), no debt, high profit margins, and 80% of its revenues are earned in US dollars and Euros. If the currency stays at its current low levels, it will have a substantial impact on Infomedia’s profit, increasing 2010 earnings (and, likely, dividends) by more than 50%.

If you want your money back in a hurry, there are a number of income securities trading at exceptionally attractive prices at the moment. These debt-like investments are listed on the stock exchange just like ordinary shares. Our favourites are the Southern Cross SKIES (SAKHA), Seven’s TELYS (SEVPC) and the Timbercorp Corporate Bonds (TIMHB), but there are more than 10 we think are attractive. They all offer returns of more than 15% a year, and in many cases you’re due to get your cash back within the next few years, giving you the chance to take advantage of future opportunities.

This simple, safe strategy will be extremely effective in a protracted bear market and provide you with returns well in excess of a cash account. Of course, if the market does roar back into record territory, you’ll miss some of the big gains. But it is, in my opinion, better to be safe than sorry.

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The author, Steve Johnson, owns shares in Infomedia as do other staff at The Intelligent Investor.

Warning: The advice given by The Intelligent Investor and provided on this website is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether the advice is appropriate to your investment objectives, financial situation and needs before acting upon it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.