Navigating a Bear Market

Strategies for dealing with current stock and economic trends

   
Navigating a Bear Market

There are many different ways to define a bear market and, for that matter, to determine whether or not it should make any difference in your investing strategy. Most people will say that a bear market is when the major indices fall by 20% or more. That has always seemed vague to me, because if the market then recovers by 1%, but it’s still down 19%, are we in a bear market?

To me, the answer is more complicated. For starters, the 20% downdraft is certainly one criterion. I also add a little technical analysis in here, but nothing too fancy. I simply look to see if the 50-day moving average is above or below the 200-day moving average of an index. If it is, that means the market has probably already experienced a pretty large drop and has not recovered.

If that moving average continues on a downtrend, the bear has control. If the 50-day moving average is above the 200-day, then the bull has control, as prices are rising. Thus, the real transition between the two is when that 50-day crosses over the 200-day in one direction or another.

Another thing to look at is the Participation Index, which shows what percentage of stocks is moving up or down. The larger the percentage in one direction, the stronger the bull or bear.

Finally, I consider the economic environment. Are conditions, in general, favorable for stocks or not?

Portfolio Strategy

If you hold a very long-term portfolio, then bear or bull shouldn’t matter. Holding stocks more than 20 or 30 years, with occasional allocation adjustments, will give you a winning hand from a historical standpoint. Nevertheless, if enough conditions suggest that we are in a bear market, there are a couple of strategies you can take advantage of to hedge your portfolio. One is to sell covered calls against half of some of your positions. This will boost your fixed income and provide cash upside to unrealized downside losses.

Another strategy is to do some allocation adjustments and shift into more-defensive stocks, such as Philip Morris International (NYSE:PM), and consumer staples that pay higher dividends.

If you are like me, however, and you devote a portion of that portfolio to opportunistic trades, you may want to engage in more aggressive hedging by opening short positions in various indices or sectors. One of my common trades is to short the S&P 500 using an ETF like ProShares Short S&P 500 (NYSE:SH). The theory is that if the overall market falls, my short will make money, slightly offsetting losses in the overall portfolio.

I also set a 7% stop loss, so that if the market suddenly recovers, I don’t lose too much on that trade.

So are we in a bear market?

Yes, I believe we are. In fact, I believe that’s been the case since late 2007, when the S&P 500 came off its highs of 1550 and hit 680. We’ve had a powerful rally since those lows, but also have had two big downdrafts — one in August, of about 20%, and another from April to October, of about 20%. The 50-day average is below the 200-day, although it is creeping up and getting close to crossing it.

The economic environment, however, is tenuous. Unemployment remains high. The government continues to overspend. Some corporate earnings have roared back, yet they aren’t redeploying those profits. Cash balances on many of the companies I profiled in the Should You Buy the Dow series are extremely high. Europe is in crisis. So is the Middle East.

I have indeed reallocated holdings to dividend-paying stocks, and have had a short position on and off at varying intervals and sizes over the past couple of years. At the moment, I was stopped out of my most recent short. I am waiting to see if the 50-day average pierces the 200-day to the upside and remains that way for a couple of weeks. If it fails, I will look to short again.

This isn’t intended to scare you out or into the market. You shouldn’t go 100% long or short based on whether or not we’re in a bear market. Your portfolio should be geared for the long term, yet have the flexibility to be tweaked in cases where things change dramatically. Keep an eye on the trend and react accordingly, but not overzealously.

Lawrence Meyers does not currently own any securities mentioned.


Article printed from InvestorPlace Media, http://investorplace.com/2011/11/navigating-a-bear-market-stocks-covered-calls-hedging/.

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