Bear Market Strategies

The two most prominent symbols of Wall Street - the bull and the bear – are associated with widespread optimism (the bull) or pessimism (the bear) among investors and traders. While it is not understood why a bear represent down trends, the most commonly accepted theory associates the bear with 19th century London bearskin market makers who would sell the bearskin before catching the bear. Other theories include the manner in which the bear fights and the way the animal holds its chin. Whatever the explanation may be, a bear market describes a long-term, downward movement in the overall market with widespread pessimism felt among traders and investors. Many people associate a 20% drop in a broad market index such as the S&P 500 or Dow Jones Industrial Average as the mark of a bear market. However, there is no “official” definition of a bear market. Due to the vagueness of what defines a bear market and the unpredictability of the markets, there can be various strategies that an investor or trader can take to help protect their capital and potentially make money.

Strategy 1: Do Nothing

Many will argue that if the media is already talking about a bear market, then it’s already too late to do anything.  Stock prices already fell at least 20%, so there may not be much more downside potential to make money. This is why many advise investors to weather the storm and do nothing during down markets. In the long term, the markets will likely return to the highs that they once reached and go even higher.  Many investors that try to time the markets and miss the big moves by being on the wrong side of the movements. Those that try to time a bear market end up selling low and buying high, the opposite strategy needed to make money. For long-term investors, typically the best strategy is to ignore the ups and downs of the overall market and be sure that you are invested in a diversified selection of strong companies that will emerge from down markets even stronger.

Strategy 2: Hedge your Portfolio

A good way to protect your investments during a down market without reconfiguring your entire portfolio is to hedge your holdings.  Hedging is a term used to describe a strategy of protecting your assets by reducing or canceling the risk in your portfolio.  Historically, trading options and shorting stocks were the most common approaches to hedging a stock portfolio. With the growth of “bear market” ETF’s and “ultra-short” ETF’s in recent years, it is now much simpler and cheaper for investors to hedge their portfolio. Perhaps the simplest strategy is to purchase shares of the Short S&P 500 ETF (symbol SH) or Ultra Short S&P 500 (symbol SDS). When the S&P 500 index falls, these two ETF’s will increase in value, offsetting the loss in the rest of your portfolio.

Strategy 3: Asset Allocation

Many financial planners focus less on picking the best companies and more time on finding the best asset allocation. The term “asset allocation” means distributing your money among a diversified set of asset classes, such as stocks, bonds, and cash.  For example, an advisor might recommend you allocate 60% of your holdings in stocks, 30% in bonds, and 10% in cash.  There have been many studies that have shown that the asset class you choose is more important than being able to pick good companies. During a bear stock market, it is typically best to have more of your holdings in cash and bonds.  This will help you weather the down market and have cash available to buy stocks when their valuations are much lower.

Strategy 4: Stock Picking

While a bear market affects the stock price of most companies, there are invariably a number of companies and asset classes that do well (or do not perform as poorly) in bear markets. No matter how bad the economy, people still need to eat, drink, and buy the basic necessities such as toilet paper, shaving cream, and for many, cigarettes. While these “defensive” stocks may do well in down markets, value investors argue that a bear market creates excellent opportunities to buy great companies that typically under-perform in bear markets.  Many investors actually look forward to bear markets because they present an opportunity to buy great companies at a low price.

Unfortunately, there is not a “correct” way to invest in a bear market that would ensure you make money.  Each individual needs to select the strategy or combination of strategies that corresponds to their personality, risk tolerance, current portfolio, and overall objective of their investment portfolio.