How Investors Could Profit from a Coming Bear Market
Bear markets certainly scare a lot of investors, and given that so many are predicting one soon, this may evoke feelings of doom. We might want to get excited instead.
In spite of all the prognostications of the end of our long bull market with stocks, the stock market continues its trek upward at the present time, even though that may come to an end at any time.
Individual investors love to speculate on these things, and many even watch the market daily even though their focus may be much further out. To be fair, things can change pretty quickly in the market, with every day bringing at least the potential for a crash, although one day losses of a magnitude big enough to get investors out of their seats is extremely unusual.
Bear markets, like bull markets, do come about fairly gradually, where the momentum shifts and we start moving in a downward direction overall. We do tend to get plenty of warning therefore when one is underway, and usually manifests in a way that leaves little or no doubt as to the trend change.
There are three main trends with stock markets, upward ones, downward ones, and sideways trends. To simplify things, we can actually just pay attention to just the upward and downward ones, and treat sideways trends as just a continuation of the current move and hang on to our positions until we get a clear sign of a reversal.
From 2009 until now, we’ve been in an upward trend, but trends don’t last forever. This will end at some point, whether it’s next month, next year, or in a few years, and when it does, this will mean that the odds of making money on the long side will be negative.
This is just not a binary thing though, bear or bull, as the potential for the trend must also be taken into account. Up moves usually have plenty of potential over the time frames that investors use, because stock prices do increase over the long run, or at least have over the history of stock trading.
If we look at where we are at now though, we could say that the upside potential is lower, for macroeconomic reasons, but as long as the trend continues, it actually makes sense to hang on to our stocks and even add to our positions, as long as we’re not committing ourselves too much here.
Not Just Being at the Mercy of the Long Side is a Big Deal
When the party does end, we need to be ready, and if we are adept, it shouldn’t really matter how much potential there is on the other side so long as there is enough. If there’s enough reason to exit from the long side though, there is an equal reason to want to be on the short side, where we seek to gain from downward movements in market prices.
If we are really committed to the longer term, where we have a strong enough preference for it, then the potential for a move will matter a lot more. Ironically, if we are really looking that far down the road, this should have us being even more eager to get out when things start looking like this is the better move. If the decision is between getting out now or staying in for that long come what may, the next few years don’t look that promising and the probabilities may favor going down at least for a few years at some point, even though this gets out early and with less certainty.
We should never be deciding this way though, and this involves a real mistake actually. We don’t need to be predicting that far out and when we try this, we will be more likely to be wrong than if we just take things as they come along. This doesn’t mean getting out at the first sign of trouble, but it does mean doing this when real signs are present, and it does not mean ignoring these just because our vision is cast too far on the horizon.
When the bears are ahead, this means that our investments on the long side have a negative expectation right now. If we choose to ignore this, this will still be true. We need to ask ourselves why we would want to place bets on something going up when the odds are against us, and even when we just hang on to our stock positions, this is in itself a bet, or at least keeping our money on the table where we could have taken it off.
If we manage trends, this will seek to have us on the right side of them more often than not, and more often than not is all we need to establish an advantage. Rather than people hanging on and crying during bear markets, they could instead be out and even be betting on that side of things if they are up for it.
Investors are taught to hold a strong bias toward the long side, and not even consider the short side actually, even though there is no fundamental difference between them. We think this way because we reason that since stocks go up more than they go down, shorting would be too risky.
While we do go up more overall, there are times when they do go down, and we also know that they will probably go down further. During these times, which we call bear markets, we at least should be considering joining the bears and looking to make money from this while the great majority of the crowd grit their teeth.
We Need to Make Sure We Keep Things Simple and Easy
Shorting individual stocks isn’t the only way to do this, where you borrow stock from your broker and sell this borrowed stock and owe the shares while you’re in the position, where you’re looking to buy it later at a lower price hopefully and return it.
Trading individual stocks is a more difficult proposition though then just trading indexes, and one of the big reasons is that indexes are a whole lot more diversified than individual stocks. Depending on the stock, it can also be more volatile than the market, those that move more in both directions than the market does.
A more suitable approach for individual investors who are looking to short in bear markets is by investing in inverse exchange traded funds, or inverse ETFs. You actually aren’t shorting anything here, borrowing anything in other words, you just buy shares in the fund and they use the collective funds to take short positions.
We do need to be careful to only do this when we are in an actual bear market, at least if you are investing and not trading, where a trader could pull this off with any pullback, including very brief ones. Investors should still be looking to keep their stocks for a fair amount of time generally, and play the bear markets of a magnitude that can produce downward movements of a significant enough duration and magnitude that they would actually be bear markets on this timeframe.
There is no real difference actually between buying an ETF and buying an inverse ETF, other than you’re looking to capitalize on expected moves in one direction or another. Your risk here isn’t unlimited as some think by betting on declines in price, and you can define it and limit it just as easily and effectively as you can with bets on the long side.
Ironically, if there is any difference in risk, it is the long side that has more of it, due to the potential for market crashes that happen so fast that we cannot react to them very well. This is pretty rare, but you could have gone to work on Black Monday in 1987 for instance and come home to a loss of over 20%, which is way beyond what could ever happen on the way up.
People who saw markets tank in 2007 for instance could have not only jumped off their long side positions but jumped on the train going in the other direction, and this train travelled a long way from there. Once this started, just about everyone knew we were headed lower but just stood by and took the losses. Instead of seeing the value of their investments get hammered like just about everyone’s did, we could have fairly easily walked away from this with a big profit instead.
Hardly anyone talks much about looking to profit from bear markets, and even fewer seek to do it, as this is thought as something far too dangerous for individual investors. The reason we think this way is that our understanding of all this is so seriously lacking, and when we do open our minds to this purported darker side, it actually isn’t so dangerous at all and in fact is considerably less dangerous than staying long and accepting whatever losses come our way.
More than anything, just having the means to profit from bear markets can really change our perspective on investing, no longer feeling so exposed to the whims of fate and actually taking much more control of our financial destinies. The goal of investing is to actively seek good returns while managing risk appropriately, and we owe it to ourselves to at least explore possibilities of reducing our risk exposure and seeking to turn what would be substantial losses into gains.
Editor, MarketReview.com
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.
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