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The average investor lives in fear of the next big drop, and rightfully so. I don't know anyone who has the luxury of tying up invest capital for the next decade just to have a portfolio at the breakeven point before factoring in inflation.

What can you do about the next bear market to protect yourself?

Go 'All In' During The Drop?

If you believe that the economy will eventually rebound, then a bear market is the time you go all in, leverage, and borrow big for the anticipated bounce after the market bottoms out. But what if the markets never do bounce back? Tell me, how many times have you seen this chart of Japan's economy that went down and stayed there?

(click to enlarge)

If this scenario plays out here, doubling down will just mean double the pain. If you are going to mortgage the house to buy stocks as they are falling (and I don't recommend this practice by the way), I would suggest doubling down on your safest bets which may have beaten up share prices but fairly stable underlying fundamentals. Perhaps getting into some electric utilities when yields jump over 7 or 8% would make sense, so that if the market goes down and stays there, you can get back your original investment in under a decade through dividends.

What else can an investor do if he wants to profit from potential upside moves but protect himself against downside losses? There are a few different tactics you can take.

Active Cash Management

The first method I recommend is to reduce your exposure to the market when risk is high. The problem is, just how do you define high risk? It seems that everything in the market is a moving target from earnings to price, which in turn makes valuation challenging. One minute the market is a great buy at this level, and the next minute, earnings tank, the trapdoor below opens and the market spirals down. How can investors determine how much exposure to the market they should have without constantly lagging the market and chasing their own tail?

I use 2 rules relating to cash management to determine how much capital one should invest. These rules are applied broadly to the market as determined by the S&P 500 (NYSEARCA:SPY):

  1. I will buy when the market is in a fundamental uptrend even if prices are dropping. Or I will buy in a technical price uptrend when the fundamentals are dropping. But I will not buy when both fundamentals and prices are dropping.
  2. Diversification lowers risk. When individual stocks become highly correlated to each other, volatility risk goes up. I only allow stocks to be held that are not highly correlated to one another. When correlation between stocks increase I sell those 'high correlation' stocks.

The net effect is that I buy during either fundamental or technical uptrends. I do not have a preference for either one. In down markets, my buying freezes, and exposure to the market decreases based on how correlated individual share prices are.

You can freely read more about this cash management system here or follow the current recommendation here. Just remember that the percent invested you should be is a simple ratio of the amount of stocks out of 500 this model is invested in; 200 stocks out of 500 equals 40% exposure, while 300 stocks is 60% exposure.

Hedging Your Long Portfolio

Another approach is to hedge your long portfolio with a short portfolio. Some take hedging to mean a broad market short fund (NYSEARCA:SH). I am not a fan of this approach, since you can just reduce your exposure to the market if that is all you want to achieve.

Consider the following portfolio with an equal-weighted mix of 5 funds:

  1. SPDR Gold Trust (NYSEARCA:GLD)
  2. SPDR S&P Dividend ETF (NYSEARCA:SDY)
  3. iShares Barclays 20 Year Treasuries (NYSEARCA:TLT)
  4. SPDR S&P 500
  5. Proshares Short S&P 500

Looks pretty good, and our short fund is smoothing out volatility. But it is also perfectly hedging our S&P 500 position. By dropping both S&P 500 funds (long and short) which are perfectly hedged and just holding 40% cash, the overall return is the same. Now hopefully you are not investing in two products with a perfect inverse correlation to each other. As a rule of thumb though, if my hedge is simply to reduce volatility, I prefer to lower my market exposure instead. When I enter a hedge, it is with the expectation that the short position has some potential to fall more than the broad market.

One short fund that seems interesting is called AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE). What I like about HDGE is that they actively use a bottoms-up fundamental approach to select stocks they feel have the biggest downside potential. What I have a hard time with is trusting that they can consistently pick good shorting candidates without seeing the strategy backtested (even if past results are not an indication of future performance). But at least your short positions have the potential to do better than a broad market short fund, since the fund managers are actively stock-picking.

Long/Short Portfolio

Another alternative is to create your own long/short portfolio, which is a type of hedge that you build and actively manage. Most investors fear that this is a needlessly convoluted process, but it need not be, if you use a platform to help you out. I will use Portfolio123's platform in the examples below.

A simple approach is to create a ranking system based on factors that you think make up a good stock. Or you can use a pre-defined one built on principles of Buffett, Graham, Lynch or some other investing guru. Creating a ranking system involves picking a factor (such as PE, earnings growth, PEG, debt to equity, etc.), specifying if higher or lower is better and then weighting the importance of each factor. I have built a fairly simplistic system based on the following factors:

  • Market cap (lower is better) 40% weight
  • Last quarter ROE (higher is better) 10% weight
  • Short percent of float (lower is better) 10% weight
  • Short interest 1 month change (lower is better) 20% weight
  • Sustainable growth rate (retention rate x ROE) (higher is better) 10% weight
  • Quarterly Price to Cash Flow (lower is better) 10% weight

Nothing too impressive to see here, but these are some of the values that I believe in. Next, I run this ranking system across a universe of stocks such as the S&P 600 (4 week rebalancing), and I long the highest ranked 100 stocks and short the lowest ranked 100 stocks. Below is the chart and stats for this massive long/short portfolio in the S&P 600. Of course, you can use far fewer stocks than this. I am trying to show the validity of the concept only.

(click to enlarge)

I use this identical ranking system and long/short approach in the S&P 500.

(click to enlarge)

Granted, this is not fully counting the cost of shorting and slippage. After factoring in these numbers, the return drops to an average annual market outperformance of 7.38% with a 0.69 Sharpe Ratio. But with an annualized return of 11.46% and a standard deviation of 11.11%, I imagine there are investors who would still jump at this.

If I was trading this S&P 500 system, I would probably short no more than 75% of my long position and have a maximum of 50 long and 50 short (or far less depending on capital and ease of rebalancing/replacing through brokerage). The below chart includes slippage and the carry cost of short positions.

(click to enlarge)

Summary

There are no sure bets when investing, or if there is, the return also reflects this. As an investor, you need to decide what is important to you. If you want the potential to make a moderate return while limiting your risk to a falling market, consider using an active short hedge strategy that selects stocks with downside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Be Protected Before The Next Market Crash