- At least eight different strategies are available to you.
- "Buffetize" your portfolio, and strengthen your basket of defensive stocks.
- You can sell calls, buy puts, or trade the VIX. Also, you can create your own personal hedge fund.
- Buy inverse ETFs, short stocks.
Talk about the likely onset of a bear market in 2014/2015 has been in the air a lot. The articles that address this topic have not emphasized enough the plight of older investors for whom a slow recovery from the expected bear market might be painful. Many of these persons would have just a few years to enjoy the fruits of their investments at the completion of recovery from the coming bear market.
The pain associated with slow recovery from a bear market could be especially acute among all investors in the following situation. They have sustained large capital losses on stocks they held only because fixed income instruments, such as bank savings accounts, had been offering a measly annual rate of return of roughly 1% per year.
Faced with this kind of threat that the coming bear market might present, it seems potentially helpful to consider a variety of possible strategies designed to promote portfolio survival and even profit making in a bear market. Articles written by several experts identify at least eight strategies. I draw upon their work to offer a survey of these strategies. This survey will highlight the ones that seem to be particularly helpful.
To set the stage for the survey of strategies, I will use the following two charts to highlight some key challenges you might face if a major bear run gets going in the next few weeks. The phrase "bear run" refers to a series of multi-day declines in the general market indexes. (During a bear market, the general market indexes tend to show a set of bear runs that are halted by short-lived rallies and sideways movements.)
Both charts shown below were obtained from the Yahoo Finance website. The first is for the SPY (NYSEARCA:SPY), based on the S&P 500, and the second is for the S&P/TSX (^GSPTSE), a composite index for the Toronto Stock Exchange). Note that the latter chart starts in 1980 while the SPY chart starts about 1993.
Here are three interesting points that the charts seem to support:
1. The bull market that started about 2003/2004 continued for roughly four years, and at its end the top was not much higher than that reached at the final height of the dot-com bubble in 2000. In the USA, the cohort that was fully invested in the index just before the dot-com crash began barely got their money back by the start of 2008. In contrast, the cohort that started investing soon after the dot-com crash reached its bottom had a wonderful multi-year ride upwards!
2. Alas, we may have a similar story to tell when the 2009-to-201x bull market ends. If it ends soon, it will mean that those who were fully invested in the index in late 2007 would have barely recouped their investment by 2014, despite all the recent hoopla about the index reaching all-time highs. At the same time, the cohort of young people who started investing in 2009 has enjoyed a great bull market since then, if they invested in the major market indexes.
3. The time taken by the index to recover from a bear market bottom is much longer than the duration of the bear market. If the bear market covered one to two years, one should expect three to five years to pass before the index will return to its height just before the first bear run started. The divergence in this regard between the SPY and the TSX (^GSPTSE) may have arisen because quantitative easing was more aggressive in the USA than in Canada.
Before going on, we should acknowledge that 2014-2015 could become a base-building period for another great bull run starting in or after 2015. However, if a 2014/2015 bear run unfolds, the cohort that started investing in 2009 will be very well represented among those "fully invested in the market" in 2014. Many members of this cohort may eventually find themselves spending as many as five years biting their nails after their ROI takes a deep dive for a year or so. A search for portfolio "insurance" (examples are given below), or for opportunities to reap profits during a future bear run could be of special interest to this cohort. Let us turn now to the "survive and prosper" strategies proposed for use in a bear market.
"Buffetizing" your portfolio
"Buffetizing your portfolio" is an eye-catching phrase that stands for a strategy whose utility was known long before Warren Buffett came along. However, he puts a special twist on the strategy that warrants our use of that phrase. Use a move into cash and similar positions to lay the foundation for buying up good bargains. These are the stocks of companies rated positively for future growth. However, their prices have been unduly depressed. You will make these purchases with money mostly obtained from selling out some of your weaker holdings.
Some forecasting that involves market timing seems inevitable, however. One would hope to sell one's weaker holdings early in the bear market cycle. Then, you would wait until it is a good time to go bottom fishing to pick up gold nuggets that scared investors or weak hands have thrown away. You should expect to hold your newly bought positions for years of slow recovery from the bear market bottom.
What are the key obstacles to executing this strategy successfully? You need the knowledge and skills required to make good stock selection, as well as good luck with timing. A third issue is the possible lack of viability of a long-term buy-and-hold strategy. "Buy and hold" may not be as helpful today as it might have been when Mr. Buffett was a young man. In these times, it is a good idea to remain nimble.
Strengthening the basket of stocks you will hold in a bear market
Building on the idea that the basket of stocks held during a bear market should comprise those with better than average crash resistance, "Mindful Money", a British information resource, advocates that you search among companies based in several countries.
All of them should be industry stalwarts whose stocks are already mired in their own bear markets. Each company should have all the following four properties:
1. The company has good earnings and dividend data going back at least 10 years (let us call this the "observation period").
2. There has been a consistent growth in earnings per share during the observation period.
3. Over that period, the dividend yields have been better than average, the dividends have been paid without failure, and the dividend per share has grown.
4. Due to a depressed stock price, the company's CAPE valuations are at levels below their long-term trend curves. (CAPE is the acronym for an index developed by Robert Schiller. It is based on the ratio of the current stock price to the inflation-adjusted 10-year average of earnings.)
Mindful Money claims that when a company's CAPE ratio tends to be below its trend curve, there is a better than average probability of delivering future stock price appreciation. The source of this outcome is the statistical tendency for the CAPE ratio to revert to the mean following divergence from it.
Having created your basket of the stocks of stalwart companies that satisfy the four named conditions, you would sit back and collect dividends while the bear market is in full swing. When any stock in your basket shoots upward in price so that the price creates CAPE valuations well above the trend line, you would take profits by selling that stock. (An alternative to buying individual stocks would be to buy an ETF whose holdings are heavily weighted with an international collection of such companies).
Let's mention some issues posed by this approach, however.
Who has the resources to assemble a rich and quality-assured international database on company earnings and stock price performance, along with associated inflation time series? These are the inputs needed to compute company CAPE ratios.
Second, what's to be done with the cash that is obtained by selling stock in what seems like the middle of a bear market? In the spirit of "Buffetizing", you might hoard the cash until you have enough to go bottom fishing as discussed above.
Third, suppose you forecast that a bear market bottom is just a few weeks away, and that selling out your profitable stock position would be a bad decision. What should you do? If the stock has highly liquid put options you might buy puts (sale price insurance) to protect your access to a desirable sale price, while you still hold the stock. If no such put options exist, you might consider setting trailing stop-loss prices.
Create your personal hedge fund
The idea of building your own hedge fund seems rather exotic, to say nothing of what that might demand as regards your knowledge and skills. However, this seems to be a good place to introduce a related suggestion made by well-known investor Keith Fitz-Gerald.
What's the key idea here? Fitz-Gerald says that a person might acquire two sets of assets, each of which tends systematically to move in opposite price directions. For example, an individual investor can become her/his own personal hedge fund manager by buying both Vanguard Wellington Mutual Fund (MUTF:VWELX) and the Rydex Inverse S&P 500 Strategy Fund (MUTF:RYURX). Fitz-Gerald suggests that the latter will assuredly rise while the former falls, and vice versa.
He sets up a hypothetical illustration in which $50,000 were placed in each of these funds on January 1, 2000. The finding from this back testing is that the personal hedge fund would have handily out-performed the S&P 500 from 2000 to 2011. Some argue that this approach is superior to the "Buffetizing" discussed above; because it does not require the investor to be bullish or bearish concerning the general market trend.
Selling covered calls along with married-put insurance
A widely used strategy, selling covered calls seems especially attractive when you forecast a sustained decline in the stock that serves as a cover for the call. What follows assumes that the reader knows the essentials of the theory about call writing, and has some experience doing so. (If you are unfamiliar with options jargon, please note that there are several books and Internet web sites where you can get help.)
Experience in options trading is important. The importance of experience arises from the need to reinforce in your brain some crucial lessons. These lessons deal with topics such as option liquidity, how the bid-ask spread can hurt you badly if you are inattentive to it, the effect of broker commissions on low-dollar trades, the challenges of trade management as the stock price fluctuates after you have taken your options position, etc. Such topics tend to be neglected in the available literature. Nevertheless, you need to get on top of them in order to use options effectively as part of your stock portfolio risk management. Some brokers will give you the chance to do options trading with virtual money until you think you are comfortable trading with real money.
Your sold call may bring you a net profit if, after your sale, the stock mostly trades sideways or gently downwards. Here "net profit" includes capital gain or loss on the stock if you sell it. (Recall that you will be required to sell the stock if its price is above your call's strike price on expiration day, or if the buyer of your call chooses to exercise her/his right to buy your stock at a time of her/his choosing.)
It is good to be always mindful of some important cautions concerning call writing. Foremost among them is the fact that a drop in the stock price to a level well below the strike price of your call could leave you facing a catastrophic capital loss on your stock. This can arise before your option has expired; because you are not allowed to sell the stock while the option contract remains open.
You can protect yourself against a catastrophic loss by purchasing an insurance put. This will allow you to buy back the call you sold, and then sell the stock at the strike price of the put. However, you need to structure your strike prices and take some other steps to prevent the cost of the put from wiping out your revenue from selling the call.
Two more cautions merit mention here:
1. If your sold call is exercised by the buyer of the call, or by your broker on expiry day, the relative positions of the strike price of the call and that at which you bought the stock create a major factor in whether you make any money (and possibly even lose a lot) because of an unexpected exercise of the call.
2. When many weeks lie between the date you sell a call and its expiration date, the stock can make a variety of price moves that set up important requirements/opportunities for options-trade adjustment, and you will ignore these moments of needed trade adjustment at your peril.
A key trick to limit your exposure to major capital loss is that of foregoing the dividends and buying LEAPS (call options that will expire nearly a year or more in the future) as the covers for the calls you sell. However, you need to be careful about the relative positioning of the strike prices of the LEAP and of the sold call. Moreover, rolling the call to prevent exercise (which means the broker will use your LEAP to buy stock to deliver) may be required for managing your loss well.
In sum, while covered call writing may be a most useful way to make money (in small amounts for each trade) in a bear market, it is no walk in the park.
Buying aggressive puts
What follows assumes that the reader knows the essentials of the theory about put buying, and has some experience doing so. If you are unfamiliar with this topic, a good place to start is the CBOE Options Institute Learning Center.
There are at least two major types of put purchase. The first is done when you wish to guarantee that stock you may sell will be sold at a minimum price set by you. This is the insurance put, already discussed.
Secondly, there are aggressive or gambling puts. Here, you are betting on a stock price fall that will be big enough to cover the cost of the put and bring you a profit when you sell your put. You are also betting that the large fall in the price of the stock will happen before your put expires. You might make this kind of bet when you hope to obtain a large profit from a stock price decline.
Once again, you need to develop experience with buying puts. (Keep in mind that some brokers will give you an account to trade with virtual money. This will not engage your emotions and test your patience like using real money does. Nevertheless, it is helpful.) A key bit of learning here pertains to the fact that the passage of time is your enemy when you buy a put (whereas it is your friend when you do the writing of calls discussed above).
A vital lesson you will quickly learn is that text-book portrayals of option price decline due to the approach of expiry day are not very helpful in real life; because concurrent fluctuations in the price of the stock can overwhelm the effect of time decay on the price of a put. Thus, you need to spend time studying alternative patterns of option price decay as expiry day approaches. Several factors are often at play here. In any event, no amount of book learning will bring you the great lessons that will be built into your trading failures.
Buying an inverse ETF
An inverse ETF is one that rises in market price when the index that it targets falls in its level. For example, an ETF that is inverse to the S&P 500 index will fall by roughly 10% when that index rises by 10%. Well known inverse ETFs include ProShares Short QQQ (NYSEARCA:PSQ), ProShares Short S&P 500 (NYSEARCA:SH), and ProShares Short Dow 30 (NYSEARCA:DOG). These ETFs track the following indexes, respectively: NASDAQ 100, S&P 500, and DOW.
George Lambert, writing for Investopedia, emphasizes that these reverse index ETFs tend to be suitable primarily for short-term trading. They also have expense ratios well above the average for funds. Finally, you face significant losses if the market indexes rise when you forecast that they will fall. For a good review of the problems of reverse ETFs and Funds see the related forum discussion at boggleheads.org. Peter F. Way, writing in Seeking Alpha, has given a neat summary of the gist of this discussion.
Trading the VIX
The VIX (VIX) is another index whose swings tend to be the inverse in direction to those in the S&P 500. The VIX is based on trading the S&P 500 options. A big rise in the volume of S&P 500 put options, relative to that of call options, is a signal that market sentiment is predominantly bearish.
The most precise expression I have found of what the VIX achieves is that given by one of its designers, Shah Gilani. He writes as follows: "It's quoted in percentage points and roughly translates to the expected annualized movement in the S&P 500 over the next 30 days. A VIX reading of 15 implies the S&P could swing higher or lower by ... about 4.33% over the next 30 days. ... The scarier the broad market decline the higher the VIX tends to go - hence its reputation as the fear gauge."
As regards how to trade the VIX, Gilani recommends iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), and S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ). He emphasizes that the VIX is best used for short-term trading strategies, where hedging of your overall portfolio is being attempted.
Making short sales of stock
This strategy is mentioned last because a high percentage of investors knows its main features. Thus, all that I say here is designed to recall its key pitfalls, and some situations when it is relatively safe.
Shorting stock and buying puts are driven by similar gambling logic, unless you already own the stock you are shorting. They are aggressive bets in favor of a sharp fall in the price of the pertinent stock. Shorting the stock has the advantage, compared to buying a put, of not having a precise date when the game must end. However, the party that loaned you stock to short may at any time demand that stock and force you to go into the market to buy it for delivery.
Thus, shorting stock is best done by experienced experts who have deep pockets, unless you already own the stock you have sold short. In that case, if your short is "called" you simply deliver the stock you own. And you may be happy to do that if you had bought the stock at a much lower price.
Another way to steer clear of the absolutely worst-case scenario is to buy a call that gives you the right to buy the stock at a pre-determined price for a fixed period of time. During that time, you would be able to exercise your option and buy the stock at your desired price. However, you will need to protect your short position on the stock by exercising the call (so as to own the stock) before the option expires.
I have said nothing about the strategy of diversifying your holdings across broad asset classes, with no assurance about their level of inter-correlation in price changes. This is because I have seen some writing to the effect that positive inter-correlations among asset classes are tending to increase. This increase reduces the utility of simply spreading your asset across the classes.
Thus, if we try to protect ourselves from the consequences of a serious bear run, we have three broad classes of strategies:
1. Deciding to move to the sidelines and hold mostly cash (and other fixed-income instruments where the nominal value of the capital is guaranteed), doing so when indicators you watch say "the Bear is near."
2. Planning and executing at least one of the strategies that imply that you will do market timing to some degree.
3. Planning and executing a pure long-versus-short hedge using two asset classes that truly oppose each other in price movement.