(With parts from My Definitive 17 Cardinal Rules For Investing Success)
Much of the speculation around the financial world over the last couple of weeks has been whether or not we are heading towards a bear market. The Russell 2000 has actually entered correction territory as of last week, and the other major market indices have had their rallies clipped by off days catalyzed by tensions overseas, combined with lackluster earnings - like those that Wal-Mart (NYSE:WMT) offered last week.
The Dow Industrials have painted an interesting picture over the last six months:
This is hardly the massive bullish uptrend we are used to seeing when we take a 6 month snapshot of the market over these last couple of years.
From a technical standpoint, the chart continues to look like it's in uptrend, but the strength of this movement is in no way pronounced. The massive, pregnant pause in the normal trading that we see ending January 2014 and starting February 2014 would likely be the first thing to catch the eye of some traders.
Since then, the market has continued to again trend upward, but investors and analysts are moving forward with a renewed sense of caution as we head into the middle of 2014.
The VIX has spiked a couple of times over the last six months, but for now it's projecting the continued picture of confidence for the markets.
Headlines on financial blogs are a different story. There's certainly a palpable discourse regarding what stage this market is in right now. Analysts on CNBC generally deduce that we're at the back end of the bull market.
With the talk of the bear market in the air, I wanted to provide three of the simple steps that I would take to prep for a bear market - remember, no matter which direction the indices are moving, there's money to be made on one side of a trade or another.
1. Take Profits in Speculative Names with High Multiples
It's been no secret that the market appears to have decided that it isn't going to love momentum names for the time being.
If you've been watching the market over the last month or so, you can see that investors are clearly less than amused with high multiple momentum stocks. As I've pointed out in a couple of my recent articles, high flyers like Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX), amongst others, have been clipped as money moves from momentum stocks to value stocks.
This money continues to move into value stocks - stocks that pay decent dividends and trade at low multiples like 3M (NYSE:MMM), Coke (NYSE:KO), Procter and Gamble (NYSE:PG) and Johnson & Johnson (NYSE:JNJ).
While I'm not one to simply advocate doing what the trend at the time is, the first step in protecting yourself would be to take some or all of the gains you've made in high multiple stocks. Then, you can re-balance. Keep them in cash for the time being if you'd like, or move them into something more conservative running the gamut from value stocks down to gold and silver bullion.
2. Make a Couple of Small Hedges
In life, we hedge. We carry car insurance, homeowners insurance and life insurance. We want to be prepared for type of disaster that life may throw at us. It's important to take this concept and carry it over to your investing portfolio.
Methods of Hedging
There are countless numbers of ways to hedge, using ETFs, stock positions and options.
- Against a long position, one might acquire cheap premium put options to protect against the value of the equity that one is holding.
- Against a short position, one might buy vanilla calls or write puts.
- Ahead of a binary event, one might play an options strangle or straddle, even in conjunction with taking a position in the equity
- Sector-wise, diversification. Money spread across several sectors protects against an industry crippling event.
- Money-wise, more diversification. Utilize bonds, funds, stocks, options, futures and commodities to make sure your style doesn't get too aggressive or conservative. Maintain balance.
In the case of our discussion here, you can hedge easily by making sure that your money isn't just in one outlook - bullish or bearish - and that it's not all in one instrument - like stocks.
Spread the money around a bit - look into CDs or something you can roll over every 6 months to a year. Take a look at the bond markets and ETFs designed to benefit from market moves to the downside (NYSEARCA:DXD), as well as residual components of a correct - higher volatility (NYSEARCA:VXX) (NYSEARCA:CVOL) (NYSEARCA:VXZ), etc.
3. Keep Your Head
As I said in the introduction, the last thing that a bear market means is that people won't make any money - so keep your head. The world isn't ending and you're not going to lose everything.
Those who buy and hold and do not have a financial education are likely to feel the effects of a bear market way more so than you - the savvy trader who understands how to position him/herself to make money on the short side.
Keeping your head is one of the most important things you can do when being an investor. The more knee-jerk your reaction is to stock moves - both up and down - the more likely you are to panic yourself into doing something you may regret. I know, because I'm human - and I learned through a long series of many screw ups.
Emotion is what prevents real success for many novice traders. Emotion is the catalyst behind making trades that make no sense on paper. Emotion is why people sell off positions after the crash and why they bag hold at the tail end of rallies. Emotion makes idiotic things run through your head, like:
"This stock may never stop going up! Better get in no matter what cost!"
"This company is doomed! We are going to zero right here, right now, on this crash!"
This may seem like idiocy when you read it now, but even the savvy investors know this voice still comes out in their head when they're in the midst of a rally or crash.
Just remember, every bear market in history has led us to where we are today - at all time highs. The market is going to hold up in the long run, nurtured by the system of central banks and central government that we have in place. We won't have a disaster of those types of proportions until we're all likely long gone. Good thing, too, because I don't want to be around to see it.
Of course, if you think the bull market is going to end furiously and want to batten down the hatches, you could always take a cue from my "end of the world" allocation, which is as follows:
- Small 5%-10% long position in staple stocks like (NYSE:GE)
- Medium-sized position in actual gold or silver bullion, and small long positions in gold and silver trusts (GLD, SLV)
- Medium-sized cash position in FDIC insured account (or several FDIC insured accounts) or in person
- Small position in volatility ETFs and ETNs to be traded in the very short term. If the VIX winds up going ape-crap, VXX will track it (at least in the short term - be wary that VXX is a long term loser).
- Medium-sized long positions in inflation-adjusted Treasuries (AAA rated)
However, in keeping your wits about you and employing these three simple techniques, you should be able to ride out any bear market - and even make a little money in doing so.
This will have you come back as a stronger and savvier investor when the wave curls back up and it's time for another boom.
Protect what you have, while you have it.
Best of luck to all investors.
Disclosure: I am long FB. 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.