How To Prepare For The Bear

Includes: EDV, HDGE, TLT
by: Craig Brockie

With 2012 so far not living up to its apocalyptic prophecies, some investors are outright disappointed. After all, just this spring, defensive stocks, US treasury bonds and even the greenback itself were experiencing extreme popularity as people braced themselves for things to only get worse.

Now we are posed to see the markets set new all-time highs. Gold is likely to make a serious run at $2,000 and the US dollar will again be getting no respect in the media. Investors will soon have forgotten the concerns they had less than a year earlier and the 2008 crash may be dismissed as a once-in-a-lifetime experience. People will likely be more concerned about missing out on the rising markets than preparing for the next leg of the bear market.

2008 was a very profitable year for the few investors that anticipated it and prepared properly. If you lost money in 2008, this brief how-to guide is designed to ensure you avoid having a repeat performance.

The good news is that it's as easy to profit from a falling market as it is from a rising one. In fact, there are three funds that reliably move inversely to the markets:

TLT is fund of long duration US Treasury bonds. When investors get scared, they sell stocks and buy treasuries. This "flight to safety" saw TLT increase 37% in the second half of 2008. TLT also pays a dividend of about 4% per year when purchased at a good price. Speaking of which, TLT is arguably still overpriced by 10-15% right now near $120. I suggest waiting to buy TLT when it's closer to $100.

EDV you can think of as TLT's wild and crazy brother. EDV is also a fund of long duration US treasury bonds however does not pay dividends. Fortunately, what EDV is missing in terms dividends, it can more than make up for in capital gains. It is because EDV does not pay a dividend that it is almost twice as volatile as TLT. As a matter of fact, EDV increased 67% in the second half of 2008. Of course, you can lose almost twice as much with EDV if you buy it at the wrong time. It is therefore even more important to wait to buy EDV.

The third fund you want to know about to prepare for the bear is HDGE. This fund is a short-seller's dream come true. HDGE actively manages short positions in a portfolio of many stocks. In case you're unfamiliar, the way short-selling works is like this: assume a stock is at $100 and we want to speculate on it dropping. We enter an order to sell short the stock at $100. What happens next behind the scenes is interesting. The broker checks their inventory to see if anyone is willing to lend us shares of the stock at $100. If the broker is successful, we get the shares and they are immediately sold into the market at $100. Now we wait for the stock to drop. Let's say we're right and a few weeks later the stock drops to $80. We may then choose to enter an order now to close the position, which involves the broker buying the shares at $80 and returning them to the lender. As a result, we make $20 on the trade minus the broker's fees. Pretty cool, huh?

While short-selling is a great strategy, it can be a frustrating experience. First of all, if no one is willing to lend us the shares, we can't open the position and miss out on the opportunity. That may suck, but what really annoys me about short-selling is that the party who lends us the shares can call them back at any time. This causes what is knows as a "mandatory buy-in" and it has happened to me enough times to never want to manage short positions myself ever again. This is what I mean about HDGE being a short-seller's dream come true. You can have a diversified portfolio of short positions and leave all the hassles to the fund managers.

HDGE is already priced pretty well here near $20, but I don't plan to buy it until we see new highs for the S&P and Dow as it's likely to get another 10-15% cheaper. That said, if you are 100% long the market right now and losing sleep over it, and holding cash is too boring for you, then parking some of your asset in HDGE below $20 might be a good solution for you.

In my next article, I'll explain what not to buy when you prepare for the bear, and why. Until then, flourish and prosper.

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.