Market swings (bears and bulls) are an inevitable part of an investor’s or a trader’s life. It’s because simply put, swings are a source of risk, and risk is a source of profit (and loss). Without volatility (if prices stayed constant) there would be no opportunity for profit. Imagine if the stock you like stayed at $20 per share, all the time. How would you profit from that? As they say, no risk, no reward.
There are two ways a price of an asset can go that you can profit from: either up, or down. In the realm of stocks and the stock market, investors usually like it when stocks go up. Contrary, they usually don’t like it when stocks go down. It’s because most investors like to buy, rather than short (selling the stock) stocks. You frequently hear the phrase “market is booming!”. Everything’s great when stocks are going up, and your investments are increasing in value. It’s generally called a “bull” market.
However, sometimes things can turn for the worse, and stocks can begin to fall. Investors then enter what they call a “bear” market. In most cases, investors are caught off guard by bear markets. Many just can’t resist investing when all they hear is that the stock market has hit another high. However, as often happens, economies tend to overheat, financial crises or simple market corrections take place. The stock market falls, and it turns into a bear market.
What are we going to discuss in this article?
In this article, we are going to look at how to best prepare for a bear market in stocks. If you want to know how to best position yourself for a bear market and which investments perform best to protect you from it then this article is for you. We will be discussing a wide range of possible solutions for both investors and traders alike.
First, we need to define what exactly we call a bear market. We will be using the most common definition which is at least a 20% fall in US large-cap stocks, from peak to trough. For those with little understanding of what that looks like, here is a little graph that summarises market movements, and what I mean by “peak to trough”.
We will be taking the S&P500 index as a benchmark for those US large-cap stocks in our analysis.
The big picture
We previously mentioned that investors like it when the stock market goes up. Why is that? It basically comes down to the fact that the economy tends to grow over time. With it, the earnings of companies grow, and hence, the stock market tends to rise. It’s simply much easier to bet on the fact that the US stock market will grow. See figure below:
Statistically speaking, if you were to invest $1 in September 1945, you would now have $154 (after inflation). That is about a 7% inflation-adjusted return per year, were you to reinvest your income from dividends. This should illustrate why there is such a big “buy” bias in the stock market. And yet this also illustrates the fact that when things go wrong, investors panic, and often don’t know where to put their money.
So, where do you put your money preparing for a bear market? What are some of the best strategies that can be used? Let’s find out.
For traders and those who are dedicated to studying the market and the economy, the obvious solution is shorting the stock market. That implies borrowing stocks from a broker-dealer and selling them. After the stock has plunged, you buy it back for less than you sold it for, and you return the shares, making yourself a nice profit. However, this is particularly risky, as bear markets are extremely hard to call. And given the bullish tendencies of the markets, it’s extremely risky.
Dollar-cost averaging is a simple, yet effective strategy used in bear markets. It basically involves buying the same dollar amount of shares, as the price drops. For instance, say, the share price dropped to $50, and you spend $200 investing in 4 shares. Next, the price drops to $40 dollars, and you spend $200 investing in 5 shares. The price continues to drop to $25, and you buy 8 shares, for $200. Now you have bought 17 shares, and spent $600. That gives you an average price of around $35 per share. The concept of this strategy is given the bullish market tendencies, the market is going to recover. The only question is when. And since calling the bottom is hard, especially for an average investor, it’s best to use this strategy instead, in order to profit from the fall.
Adding bonds to your portfolio is another prudent strategy for investors who want to preserve the value of their portfolio during a downturn. It works because first, bonds usually pay a coupon, which is an annual payment worth some interest rate. For instance, a bond with a 5% coupon would pay $5 yearly for every $100 bought. Not only that, since bear markets are often accompanied by economic/financial crises, what usually happens is, the Fed cuts interest rates. That increases the value of the 5% bond you’re holding, compared to a now, say 2% bond. So, bond prices go up and so does the value of your investment. Let’s look at some interesting data by UBS on bond investments during bear markets.
This table shows how adding more bonds (intermediate duration) to your portfolio can save your losses during a bear market. The first column on the left shows the stock/bond allocation (how many % stocks, and how many % bonds). The second column from the left shows the average loss from a post World War 2 bear market (peak to trough), given that allocation. The 5th column from the left (Worst drawdown) shows the worst loss (which coincidently was the most recent financial crisis of 2007). We will not focus on the rest of the data for now. So, basically what this shows is that as you add more bonds to your portfolio, your average and worst losses tend to shrink. More bonds during a bear market -> fewer losses.
That said, a short note on the current economic climate should be given. We are now in a rather low-interest-rate environment (2.25-2.5% Fed funds rate). That means, bond yields are also quite low. So, if you are expecting a bear market to start any time soon, you might reconsider adding bonds to your portfolio given these particular market circumstances.
Another good strategy in preparation for a bear market is to add gold to your portfolio. Gold has long been a so-called safe-haven asset. What that means is that it tends to increase in value when there is increased risk and volatility in the markets. This is a good sign for you as an investor because bear markets are accompanied by jus that. Let’s see how gold has performed during the downturn of the most recent financial crisis.
As we can see, even though the S&P500 index has dropped by over 51%, gold has risen by more than 23%, over the same period of time.
Buying defensive or countercyclical stocks
You might think that when a bear market hits, it’s time to get out of the stock market completely. However, some stocks perform better than others in a bear market. Or, at least, less poor than the overall index. Usually, these are either defensive or countercyclical. Defensive stocks are those that retain stable earnings and pay dividends during a downturn. Examples of such companies could be utilities, consumer staples, and healthcare companies. The reason that they are stable stems from the fact that demand for their products is stable even during downturns. For example, you will always need food, water, and healthcare, whatever the market situation. Hence, people have a rather steady demand for such products and the share prices of these companies are more stable. Not only that, as mentioned, they often pay a dividend.
Another category of stocks that perform better in a bear market is countercyclical companies. These are companies that usually perform even better in market downturns. Examples could be alcoholic beverages, discount retailers or even entertainment companies. It’s because when times are tough, people tend to choose cheaper products. Not only that, they often tend to turn to alcohol or gambling addictions as a way to escape the harsh reality.
Let’s look at some examples of how such companies performed during the most recent bear market:
In this rather large graph, we can see different companies’ performance compared to that of the S&P500 index. Most of these are either defensive or countercyclical stocks. As an overall analysis, we can clearly see that these companies have outperformed the S&P500 index by a whole lot. Wallmart, a well-known retailer has even managed to gain in value during the bear market of 2007-2008.
Investing in options
Options are one of the more complex instruments available to investors and traders alike. However, if you know what you are doing, they can provide a low risk, high reward solution suited for bear markets. We will not delve deep into options trading in this piece as it’s simply out of the scope of this article. However, let’s explore one particular strategy that you can use in a downturn. That is, buying a put option. What is a put option? Basically, it’s an option to sell a stock at a predetermined price (called the strike price). The following graph summarises a long put option:
Basically, the vertical line shows your profit/loss, while the horizontal line shows the price of the stock. In a long put option, if you agree to be able to sell a particular stock at a particular strike price, you will have to pay what is called a premium for the option. If the stock price rises, you will only lose the premium as you will not exercise the right to sell the stock at the strike price. However, if the price drops, you can sell that share at the strike price and buy it at the current lower market price, and make yourself a nice profit. This strategy is perfect for bear markets because of high reward, low-risk scenario. That said, oftentimes in bear markets, option premiums are quite high.
A note on cryptocurrencies (Bitcoin)
I also wanted to touch upon a popular, yet often misunderstood topic. That is, investing in cryptocurrencies (Bitcoin) in bear markets. Many people will have the assumption that it’s a good idea to invest in them in bear markets. After all, Bitcoin was created in 2009, as a reaction to the financial crisis of ’07. And after the creation, it soared to astronomical levels. So, it should follow that people have more trust in Bitcoin in rough times, right? I would be very careful with this assumption. For one, while it does make sense that during a financial crisis people have mistrust in banks, and turn to alternative payment options, such as Bitcoin, not every bear market will be accompanied by a financial crisis. Since we haven’t had a proper (20% fall in stocks) bear market since the financial crisis of ’07, the closest example I can think of to test Bitcoin’s performance in a bear market is in 2018 when the stock market fell by around 19%. So, how did Bitcoin performed during that same period?
It actually fell by more than 42%. Also, it was well correlated with the S&P500 index. So, my conclusion is, be careful about what kind of a bear market it is before investing in cryptocurrencies as a hedge against the stock market.
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In this article, we have discussed some of the most common and best strategies for investors and traders alike. From shorting the market to bonds, gold and even put options. There are countless strategies available and we only had the limited scope to discuss a few of those. However, hopefully, this shows that even in the worst of times, there is hope and profit to be made, or losses to be cut.