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So what should you do if you agree with me that we're looking at a bear market in stocks? I've got five rules for dodging the worst of the bear. They're a result of my painfully expensive education at the hands of the 2000-02 bear and research into how earlier bears have played out. (The best book on the history of bear markets for my money is still John Rothchild's "The Bear Book: Survive and Profit in Ferocious Markets.")
- Sell early. If this is a bear, there's no point hanging around. Sell now rather than later. Why? You want to avoid as much of the bear market losses as possible. You want to avoid being one of those courageous investors who hangs on through a 19% decline but then can't stand it and sells at 20% down. Buying high is one way to lose money in a market. The other is selling low. And that's what you'd like to avoid. Selling now also helps clear your head. Instead of fighting the last battle, you're ready to look forward to making money -- with the cash you've got in hand -- when the market turns in your favor.
- Get over yourself. No investor likes to admit a mistake, and so you hang on to stocks down 20% or 30%, hoping they'll move up to break even in the next bear market rally. And then you'll sell. This sets you up for more losses as the bear runs its course, and it means that you're likely to be selling when the rally that marks the end of the bear finally comes -- at exactly the time when you should be buying. But, hey, investing isn't about being perfect, and making a bad investment isn't a judgment on your moral character or intelligence. All investors make mistakes and pick losers. All we can hope for is to pick more winners than losers.
- Don't count on past winners for safety. In a bear market, almost everything gets sold. Worries about the U.S. and global economy have already taken a big bite out of energy and industrial commodity stocks (copper mines, for example). That's not unusual. Those commodity sectors sold off in past bear markets, too. Looking back to previous bear markets, about the only sector able to buck the trend has been gold. Gold stocks are in their own little correction now because of a drop in sales of gold into India's jewelry market, the biggest market for physical gold in the world. But this is just a correction in gold, which will likely be one of the few havens in any 2008 bear market.
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- Cash isn't trash. Rethink your definition of a good return. A 4%-to-5% return might look puny when stocks are moving up 15%, but it's a darn sight more attractive when stocks are plunging. That cash on the sideline can earn you 5% in a certificate of deposit now (keep the maturity short -- six months -- so you can put this money to work when the bear is over). Bonds are yielding less than that now, but with the Federal Reserve expected to launch more interest-rate cuts, your total return from a bond could well be higher (bond prices climb when interest rates fall). Stick to safe U.S. Treasurys and to relatively short maturities, such as two years, so you avoid losses from resurgent fears of inflation.
- Hedge with an inverse exchange-traded fund. In the past I wouldn't have recommended anything like this. For investors unfamiliar with options and shorting, a bear market certainly is no place to take a crash course. But with the advent of ETFs -- funds that trade like stocks but hold a portfolio of assets like a mutual fund -- that's changed. You can now buy an ETF that goes up when the Nasdaq or S&P 500 or the Russell 2000 Index ($RUT.X) goes down. And you can even buy an ETF that goes up twice as fast as the index that it tracks goes down. So far in 2008, these ETFs are doing exactly what they're supposed to: The Short QQQ ProShares (PSQ, news, msgs), which bets against the Nasdaq-100 Index ($NDX), was up 13% this year as of Jan. 18. (Be careful chasing returns on the short end. Monday's rout in the overseas market suggests we're getting close to a bear market rally, and you don't want to go short just in time to be killed by a rally. The time to put on a hedge like this is near the end of a rally -- not during the panic that often marks a temporary bottom to a bear market.)
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A shining turnaround?It looks like the market may be falling for the next six to eight months. Even gold, a traditional haven, is taking a licking. But gold will likely come back before stocks do, says MSN Money's Jim Jubak -- because buyers will return to the jewelry market as prices drop.
Which mix of these five suggestions you chose to follow depends on your portfolio, your investing horizon and your own psychology (you know how much pain you can stand). The closer you are to needing your portfolio, the more aggressively you should protect it. The less prone you are to panic, the less you need to worry about selling at the bottom. But I think raising cash so that you're ready for the next bull market is a good strategy for anyone fighting a bear.
Continued: Updates and developments
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