Investing in a falling market can be very challenging.
The number one concern of any investor in a bear market should be to protect their capital. When the market falls by ten, twenty, thirty percent, or more during a bear market, how do you do this?
Most investors have very little experience investing in a protracted bear market, one which lasts many years. It’s difficult to say whether the period we are entering will be a short, shallow correction, or a longer, deep bear market. Investing during a bear market requires a completely different strategy than investing during a bull market. Many of the buy-and-hold proponents neglect to mention that stocks went nowhere for long periods of time–like 1929-1953 and 1965-1981. Adjusted for inflation, stocks dropped quite a bit during these periods. Regardless of how things turn out, I’ll give you some insights into funds which perform well in bear markets, ways of diversifying your investments into foreign currencies, and some information on investing in deep bear markets in real estate. I’m gearing this article primarily to those living in the US, or those who have access to a US brokerage account, although some of the advice would apply in many other countries as well.
An Introduction to Bear Markets
For anyone with an understanding of investment terminology, I recommend the book, “Anatomy of the Bear” by Russell Napier. It’s a study of the four great bear markets in the US during the twentieth century. This book centers on understanding the signs which are present to signal the end of bear markets, and the cycle of stock markets in moving from overvaluation to undervaluation. A key finding is that, on average, markets move from peak overvaluation to being most undervalued over a period averaging fourteen years. The US market peaked in 2000, so it could be a few years before it bottoms out–somewhere between 2009 and 2014, if things play out this time like they have in the past. Incidentally, the Japanese stock market exhibited a cycle length of very close to fourteen years from it’s peak in 1989 to the trough and recovery beginning in 2003. I will leave the prognostication as to whether we are entering a bear market to other people, but this book will give any reader insight into how bear markets operate. This information alone might save a serious investor a great deal of money (or make him a great deal of money) should a protracted bear market materialize. While not geared specifically to bear markets, The Economist magazine (http://www.Economist.com) is a great resource for information on markets, economics news, and specific industries. Some of their calls are very accurate (they predicted the dot.com bust and the real estate debacle) and some not so accurate (their predictions on oil prices circa 1999 and gold prices circa 2004) but always thought provoking. They don’t cheerlead specific companies or stocks, and seem to be among the more objective sources of economics news.
Bear Market Funds
For those who feel that the market has entered a bear market, or a serious correction, there are a number of specialized funds which are geared to increase in value as markets fall. A web site which contains a large number of these funds can be found at: http://bearmarketcentral.com/mutualfunds.htm. I should first mention that these funds are not for the faint of heart. If the market increases, most of these funds will drop. Some of these funds (the Ultrashort funds) will increase or decrease twice the opposite of the movement of their underlying indices. Others increase or decrease based on the inverse of their index (such as the Short Russell 2000 Index, which increases as the Russell 2000 falls). Most of these funds are reverse index funds–as their underlying index decreases (or increases) they increase (or decrease), so there is little active management. One actively managed bear market mutual fund is the Prudent Bear Fund (BEARX). This fund has been around longer than most (since 1995 or so), is larger than most, and seems to change strategies somewhat, depending on the market. Generally, this fund seems to drop less in value than most bear funds in a rising market, while still responding well to a falling market. They also have a very informative web site at: http://www.prudentbear.com. The fund manager, David Tice, seems to have an excellent handle on what it takes to operate in a bear market successfully. Prudent Bear funds also operate the Prudent Global Income Fund (PSAFX). This fund invests largely in government bonds from Europe and other parts of the world, and thus benefits from a falling dollar. More sophisticated investors may wish to short-sell stocks themselves, but short-selling individual stocks can be a tricky process. Using a mutual fund or Exchange Traded Fund which does the short selling for you simplifies things considerably.
Bear Market Fund Strategies
The first general difference in bear market funds would be mutual funds versus Exchange Traded Funds (ETFs)
For those who aren’t too familiar with ETFs, they trade like a stock, no holding period, prices fluctuate during the trading day (as opposed to being set at the end of the trading day for mutual funds), and there are no minimum purchase requirements. An ETF may be more flexible for the average investor who wishes to begin some sort of bear-market strategy, and who doesn’t want to begin with a large minimum investment, as is necessary with some mutual funds.
There are also many sector-specific bear funds, so if you are particularly negative on a particular sector, you can seek to profit from any falls in that sector.
Pro Funds (http://www.ProFunds.com) has the largest number of offerings of bear-market mutual funds.
Ultra Short S&P 500 (BRPIX) – seeks to move the opposite of the daily performance of the S&P 500 index.
Dollar Short (FDPIX) – seeks to move the opposite of the movement of the US Dollar Index. Short Oil and Gas Pro Fund (SNPIX) – Seeks to produce inverse results to the Dow Jones US Oil and Gas Index
Short Real Estate Pro Fund (SRPIX) – Seeks to produce inverse results to the Dow Jones US Real Estate Index
Read about more of their funds at the ProFunds web site, or at the Great Bear Funds Web site, http://www.bearmarketcentral.com/mutualfunds.htm.
Pro Shares has the largest number of bear-market Exchange Traded Funds, and is the king of Ultrashort funds–funds which seek to move double the inverse (opposite) of their relevant indexes.
Some of their funds include:
Ultrashort Consumer Goods (SZK)
Ultrashort Health Care (RXD)
Ultrashort Industrials (SIJ)
Ultrashort Oil and Gas (DUG)
Ultrashort Real Estate (QID)
Ultrashort Technology (REW) ProShares has over twentyUltrashort funds, and more information can be found at the Bear Market Central site, or at http://www.ProShares.com.
Safe Places to Park Your Money
Money market funds are a good place to put your money while waiting out turbulence or while researching other opportunities.
However, all money market funds are not created equal. Funds which invest in commercial paper or CDOs or any number of exotic investment vehicles have recently experienced quite a bit of uncertainty, due to the sudden changes in the credit market.
A good bet for safety and liquidity is a money market fund that invests 100% in US 3-month Treasuries. Most of the large brokerages offer their own funds. For example, Vanguard offers the Vanguard Admiral Treasury Fund (VUSXX). It generally pays a bit less than the Fed Funds rate–it’s currently paying around 1%.
Another bet to park your money is a GNMA bond fund. One of the biggest is Vanguard’s GNMA fund (VFIIX). If you can handle some fluctuation, it’s a good bet–not really a money market fund since it invests in government-guaranteed mortgages, but it does pay around 4.5% at the time of writing, so it’s better than most things out there.
A couple of other bets are the Vanguard Short Term Treasury Fund (VFISX) and Vanguard Short Term Federal Fund (VSGBX). Both pay around 2%, and there can be some fluctuation in the asset value, but it’s a safe place to park money.
If bank CDs are your thing and you don’t mind a dealing by mail or on-line, Everbank (http://www.Everbank.com) is a good bet. They rarely offer the highest rates, but guarantee to be within the top 5% of banks in paying interest.
There are all sorts of ways to get very high interest now–junk bonds galore–but we seem to be entering a period of tighter credit and increased defaults. Is it worth risking the loss of all or a large part of your money in a default? Interest rates for all sorts of riskier credit are on the rise, and any long-term bonds which carry a higher risk will tend to drop in price as we go forward. It may pay to take a breather from risky bonds for now until the view clears up a bit.
In the last few years many investors have taken a very cavalier attitude toward risk, but it seems that the cycle has changed. When the cycle changes, it makes sense to change your strategy.
In a prolonged asset bear market many assets can become very cheap, but only those with ready cash will be able to take advantage of opportunities. For most people it makes a lot of sense to take money off the table, and wait for better opportunities. Buy-and-hold investing is all well and good, but why hold while asset prices are dropping 30% or more?
Foreign Currency Funds
Currencies tend to rise and fall over time, and short term trends often reverse themselves. Currency trading is a complicated business, and full of pitfalls.
For those who would like some foreign currency exposure and still be able to sleep at night, there are a number of new Exchange Traded Funds that make things easy. The web site ETF Connect has information on a number of currency funds at: http://www.etfconnect.com/select/FindAFund.aspx. Rydex Funds offers their Currency Shares Trust in various currencies–Australian Dollars (FXA), British Pounds (FXB), Canadian Dollars (FXC), Euros (FXE) and Japanese Yen (FXY) among others. See the Rydex web site at: http://www.rydexfunds.com for further information. These funds allow you to purchase foreign currencies with little effort–just a call to your broker. There is no leverage, it’s basically like opening up an interest-paying foreign currency account, but without the hassle and reporting requirements to Uncle Sam.
The British Pound is taking a beating at present, so it’s probably best to steer clear of that.
Precious metals can offer additional diversification in bear markets.
Until recently, all investments seemed to go up in price, just at different rates. Real estate, bonds, precious metals, stocks, commodities, etc. Some people think it’s conceivable that most investments will also go down in price at the same time, as money becomes tighter and speculation drains out of the markets and things return back to fundamentals.
So it’s possible that precious metals prices could drop along with prices for a lot of other things.
If, however, you think that precious metals are a way to diversify, you might consider purchasing some gold and/or silver if you haven’t already done so.
There are a variety of web sites where you can go to purchase physical gold–http://www.kitco.com, HYPERLINK “http://www.GoldMoney.com” http://www.GoldMoney.com http://www.BullionVault.com etc. I can’t tell you which is best for you, if any, but I suggest that you research these if you want to purchase physical gold.
You can also go to your local coin dealer, but you may be able to do better on price with one of these companies.
If you would rather make things easy and don’t need to have gold or silver in your hands, you might consider one of the Exchange Traded Funds which deals in precious metals. My emphasis here is on funds which own precious metals directly, not mining companies.
I’m not going to talk about gold or silver mining shares, since owning shares in mining companies is another matter altogether than owning physical gold or silver, and a matter which is beyond my expertise.
The iShares Comex Exchange Traded Fund (IAU) holds gold in a vault, and issues shares of ownership in their gold, each share representing ownership of 1/10 ounce of gold. The Streetracks Gold ETF (GLD) also issues shares representing 1/10 ounce of gold, basically the same structure as the iShares fund. These funds trade a few cents apart, most likely due to the small difference in expenses.
The iShares Silver Trust ETF (SLV) holds silver in a vault, and issues shares which represent ownership of 10 ounces of silver.
There are all sort of arguments as to why you should or shouldn’t own these funds, some people saying that you should only own gold that is allocated to you physically (basically it has your name on it), or that you should only own gold that is actually in your physical possession. I’m not going to get into all those details, except to say that for some people it’s just a lot easier to own gold or silver as if it were a stock, and that these are large, well established investment companies with a number of safeguards.
These funds–GLD, IAU, and SLV generally trade at the price of gold or silver (1/10 ounce for gold or 10 ounces of silver for SLV) less the expenses of the trust. The expenses of the trust will accumulate over time, so that the price of the shares will tend to decline over time by an amount which reflects the total accumulated expenses of the trust. In other words, these funds will trade at a slight discount to the metals prices, and this discount will increase over time to reflect the expenses of storing the metals and administering the funds over time. So that’s why they trade at slightly less than the underlying cost of the metals.
Whose Advice to Take
The world is full of investment advisors, many of whom have one thing in common: they want to sell you something, preferably for a large commission.
One source of objective advice is Hulbert Financial Digest, which can be ordered at: http://www3.marketwatch.com/Store/products/hfd.aspx?siteid=mktw&dist=. Their rates start at $59 for a year.
This publication rates all the widely available investment newsletters which offer specific investment recommendations. Hulbert does not offer specific investment recommendations, but they do rate the recommendations of many different newsletters, and also show the most widely held funds and stocks of the newsletters.
You can then purchase the newsletters which offer strategies which suit your own needs. Some of the newsletters have odd strategies which might not suit you, but this rating system gives you the opportunity to learn a bit before buying a subscription to a potentially useless newsletter.
Hulbert has ratings for one year, five years, ten years and so on. As they will tell you repeatedly, it’s unwise to assume that just because a newsletter had a great year, that they will automatically have a great following year.
Many investment newsletters promise large returns which are difficult to verify. Hulbert cuts the unsubstantiated promises down to size and gives you a basis to compare different newsletters and their strategies.
Investments to Avoid
In life, it’s sometimes as important to know what you don’t want as knowing what you do want.
It’s no different with investing.
In general, most people would be best to think twice about investing in a wide variety of bonds and leveraged investments. FNMA bonds, high-yield corporate bonds, any kind of mortgage backed securities, any kind of exotic lending. My reason is that risk is being re-priced, and prices of many bonds, CDOs, mortgage-backed securities and so on will be re-priced lower once their real risk is priced appropriately. The recent turbulence probably isn’t a temporary glitch which will last a short time before a return to the “good old days”. Many people are unaware that 70% of US corporate bonds are rated “junk”, and only about half a dozen companies have AAA rated debt. Credit standards have deteriorated drastically.
In addition to bonds, there are many other investments which are very sensitive to interest rates and the availability of low-interest money. These investments will also tend to fall in price, relative to other investments which are not so interest-rate sensitive.
Some examples would include commercial real estate, auto manufacturers, and anything related to residential real estate (home builders, mortgage companies, and some banks). No more easy financing equals fewer customers equals lower profits. In the case of commercial real estate, higher interest rates tend to equate to lower cash flow, and with the cash flow being valued at a lower multiple.
Emerging market bonds are another investment that should be avoided by most investors. Until recently many emerging market bonds were yielding only slightly more than US Treasury paper. Many emerging market countries do have much more in foreign exchange reserves (mostly US dollars) than in the past, but it would still seem that the risk/reward ratio is being priced far too low. A currency crisis is unlikely in a country with large foreign exchange reserves, but it is possible that at some point investors will demand a much greater return on emerging market debt once the easy financing goes away (as is happening right now).
Some emerging market countries with high-flying bonds have defaulted on their bonds or had currency crises or inflation crises within the last fifteen years or so (Mexico, Russia, Argentina, etc). Times have changed, but it’s still something to think about. Emerging market debt has had a long run on the up-side, it might be time for a breather.
A couple of years ago John Templeton (founder of Templeton Funds) mentioned that he felt that there were hardly any bargains anywhere in the world. This coming from the man who practically invented international investing.
Commodities in the past have not been closely correlated with the stock market. It can make sense to have some exposure to commodities.
In the past, the drawback was that you usually had to open an account with a commodity broker, and most commodity positions involved trading on margin. Relatively small moves against you could wipe you out.
A number of funds which invest in commodities have come on to the market in the last few years. A good discussion is at: http://seekingalpha.com/article/35966-commodity-exposure-via-etfs-a-fund-manager-s-process.
One caveat: many commodity funds have weird tax treatment. Do a bit of research on whichever funds you might be interested in before you invest.
PCRDX is the no-load equivalent of the Pimco Commodity Real Return fund.
Another caveat would be that many commodities may have also been inflated in price recently by speculation, since credit has been ultra-easy to obtain. There may be a speculative premium in some commodity prices which might fall out, particularly if the US economy enters a deep recession.
Renewable energy stocks have shot up in the last several years. The prices and valuations for many of these stocks are reminiscent of dot.com stocks.
For those who do want to invest in renewable energy companies, the New Alternatives Fund specializes in wind and solar investments (NALFX).
For many people, the best investment in renewable energy would be for the home where they live. If you plan to stay where you’re at for a while, it could make sense to invest in some sort of renewable energy.
The best return on investment in renewable energy is usually solar hot water. If you currently heat water with electricity, and live in a climate with even moderate amounts of sunlight, it can make a lot of sense.
Installed systems start around $3,000-3,500 in areas where hard freezes are common. In mild climates like Florida or south Texas, systems can be much cheaper since the design doesn’t need to withstand freezing temperatures. Systems being installed now are vastly better than those from the early 1980s, when the main incentive was tax credits.
Solar electric systems (photovoltaic, or PV systems) may or may not pencil out, depending on where you live, the availability of state and local rebates and so on.
For further research, the best source is Home Power Magazine, http://www.homepower.com. The magazine is full of articles which show how systems were installed, costs, even return on investment calculations. Some of the articles may be a bit technical, but you don’t have to be an engineer to see how it all works.
Cutting your utility bills is like more income, and it isn’t taxable. Plus, reduce CO2 emissions.
While I’m on the topic, conservation can be the best investment of all. If your furnace or air conditioner or refrigerator are over ten years old, you might save significantly with new equipment. Technology has improved quite a bit in the last few years–new refrigerators use a fraction of the electricity of those made only ten years ago.
The Good, The Bad, and The Ugly
With the stock and bond markets gyrating, many people will be very anxious to find investments which will provide high returns without so much risk.
There will no doubt be lots of new “guaranteed return” investments coming out of the woodwork to take advantage of the situation (as well as some investors).
It’s hard to say what the next Flavor of the Month will be–we’ve gone from the dot.com bubble to the debt-mortgage-real estate bubble. What I can say is that you should be very skeptical of any “new” investments coming on line. Some of these will no doubt be pushed by some of the former salespeople from the last bubbles, who are out to strike it rich in the Next Big Thing. It would be great if we could trust everybody, but it just doesn’t pay off.
It might be a good time to sit on your hands and play it safe for a while. Jeremy Grantham, one of the all-time greats of Wall Street, has an interesting take on the whole situation, at: http://www.thestreet.com/funds/followmoney/10353243.html. The title of the article, “All The World’s A Bubble” says volumes.
Best of luck in all of your ventures.