How Not To Prepare For The Bear

by: Craig Brockie

The bull market that began in early 2009 is getting very long in the tooth and is unlikely to make it beyond its fourth birthday. I expect the subsequent bear market to be more severe than we experienced in 2008, similar to how the collapse from 1930-1932 was far more epic than the infamous stock market crash of 1929. If you suffered losses in 2008, it's critically important to be better prepared this time around.

In my last article, I explained the proven ways to profit in a bear market, when assets of almost all varieties are falling in price. Today's article will explain the pitfalls to avoid when playing this same game. Like most things, when it comes to investing in a bear market, misinformation and conflicts of interest can lead to your demise. Knowledge of the truth is power.

Lesson #1: Gold Bugs Get Squashed

Gold Bugs make strong arguments for the yellow metal being a safe place to store one's wealth. Over the long term, I agree with them. In fact, had one acted on their sage advice and invested in gold back in 1999 when it was trading near $250 per ounce, you would be very happy today indeed. Unfortunately, if you are preparing yourself for a devastating stock market decline, gold (NYSEARCA:GLD) has a proven track record for being a bad choice. In 2008, gold prices dropped 30% right along with the tumbling stock market. Silver (NYSEARCA:SLV) fared much worse, plummeting over 55% in the same period.

And don't for a second buy into the persuasive story of a promoter of gold mining companies as a safe haven for your capital in a declining stock market. Think of the stock markets as a whole like the tide of an ocean and each individual company being a boat. When the tide comes in, all boats rise. When the tide goes out, all boats drop. You don't want to bet on any company going up in a falling stock market. In 2008, gold mining companies (NYSEARCA:GDX) as a whole dropped almost 70% and some individual gold companies, Helca Mining (NYSE:HL) being just one example, plunged 90%!

Lesson #2: "Bear Funds" For Dummies

Once you start researching bear market investing, you're invariably going to stumble across investments marketed as "short" or "bear" funds. The companies Proshares and Direxion offer the most popular of these funds, which are available in many flavors. (NYSEARCA:DOG), (NYSEARCA:SH) and (NYSEARCA:PSQ) are your vanilla short funds for the Dow Jones, S&P 500 and Nasdaq indexes respectively. If that's too boring for you, you can get more exotic by going double or even triple short various market sectors. For instance, you can go 2:1 short oil producers with (NYSEARCA:DUG) or 3:1 short with (NYSEARCA:ERY). Another popular bear fund is (NYSEARCA:FAZ), which is triple short the financial industry.

While it may sound exciting and intelligent to be triple short the financial industry leading into the next bear market, unless you're a day trader, these funds are better left alone. The reason is that the way they are designed, short funds only correspond to daily performance, not long-term performance for the indexes they relate to. Unfortunately, over time these funds erode in value and the effects get worse the longer you hold them. I won't get into the mechanics of why this is, but rather show you this chart which shows just how bad price erosion in short funds can get. The red line shows the performance of oil and gas stocks over the past year and the blue line is ERY, a 3:1 leveraged short fund for this sector. Pretty bleak picture, isn't it?

Buying short funds is like trying to run up an escalator that is headed down -- it's still possible, but there are easier and better ways to get where you want to go. The ongoing price erosion that affects short funds makes them a poor choice for the wise investor. As I mentioned in my previous article, there are reliable ways to profit from a falling market, but buying bear funds aren't one of them.

Lesson #3: Leave Options Trading for the Pros

Some might suggest to you that you consider buying stock options to profit from a falling stock market. I've yet to meet someone who successfully dabbles in options trading and believe this game is best left to the pros who specialize in it. Expecting to be successful at buying options is like walking into a casino and expecting to walk away richer. The prize can be high, but most trades end in disappointment with over 75% of all options contracts expiring worthless. While it is possible for you to be the casino by selling options to others, doing so carries its own unique risks and is not as straightforward as it might sound. Again, my suggestion is to leave options trading to the pros.

Lesson #4: Volatility is Very Tricky to Play-Directly

I absolutely love volatility. Without changes in volatility, investing would be pretty boring and offer far less opportunity. VIX is the most common gauge for volatility and I keep this symbol at the very top of my stock app list because of its value to instantly determine what's happening in the market on a given day.

Right now with VIX in the mid teens, one might get excited about the prospect of betting on it going higher. The last bear market VIX peaked around 80, which would be an increase of over 5x from today's levels. If there were a reliable way to bet on VIX increasing, I'd be fully onboard with doing so. (NYSEARCA:VXX) is a fund which rises in value as VIX rises. While a good idea in theory, by design VXX is as bad or worse than the bear funds mentioned above in terms of ongoing price erosion. Rather than explain why VXX erodes in value, let's just analyze its historical results. This chart shows how badly this fund erodes in value relative to VIX. It's clear that VXX is another losing proposition over the long run.

I may receive criticism from those who believe we won't experience another bear market as severe as 2008 or who have had success investing in the funds mentioned in this article. That's okay; everyone is entitled to his or her opinion. Things could be different this time and gold could rise as stocks fall, but I wouldn't bet on it and won't be. Short funds, put options and VXX will make you money if you're timing is impeccable, but as my good friend and mentor, Steven Kaplan emphasizes, the markets work on their own schedule not ours.

The key to consistently winning in any game is to maximize the odds of success in every given situation and investing is no different. Betting on any of the investments mentioned in this article reduces our probability of success. When there are proven ways to handsomely profit from a bear market, why take undue risks?

As I write this, I am completely long the markets and am expecting another push higher over the upcoming weeks before the markets begin heading south. Today is the time to prepare for the upcoming bear market, not place your bets on an imminent stock market crash. The main reason I've published these articles now is so you know how to win before the game even begins. Too many good people were caught by surprise in 2008 and suffered. I sincerely hope that you and yours "Conquer Crash" this time around.

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.

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