You can no longer afford to just ride out a bear market.

next-bear-market

How do you define a bear market and, for that matter, does it even matter?  If the market is down 19%, it isn’t “officially” a bear market, but trust me, you’ll be as depressed as if it were one.

I go beyond this simplistic definition.  The questions I ask are whether the overall economic environment is headed in the wrong direction, if corporate earnings are headed down or are slowing in their rate of ascent, if the market has fallen at least 10% off its highs, and the overall sentiment.  This may be reflected in something called the Participation Index, which shows the percentage of stocks moving in a given direction.  If the trend has turned so that more than 50% are headed in a down direction, that’s suggestive of a bear.  Finally, I’ll look at the charts of the major indices.  If the 200 day moving average has crossed and is staying below the 50-day moving average, that acts as a kind of confirmation.

Now, if you hold a very long-term portfolio, then bear or bull shouldn’t matter. Holding stocks more than 20 or 30 years, with occasional allocation adjustments, will provide you with an upward bias on your returns.  Still, if enough conditions suggest that we are in a bear market, there are a couple of strategies you can take advantage of to hedge your portfolio.  It may not be necessary to do so, but you may choose to do so.

One is to use some options strategies, as highlighted in our Options Advantage newsletter.

Another strategy is sell out of some of your more aggressive growth holdings, and into what are commonly known as defensive stocks.  These are stocks such as Philip Morris International (NYSE:PM), and consumer staples, which are products that people need to buy – things like food, toilet paper, and basic necessities.  These stocks may modest dividends to help offset losses elsewhere.

Another tactic is to take advantage of the recent additions of ETFs that swap out market-cap weighted indices for those that are equal-weight.  In this case, every stock holds an equal position with all the others in the ETF. Thus, they all must move together for the ETF to move in any significant way.  This way, a small cap stock can have just as much influence on the ETF as a Google (NASDAQ:GOOG).  The result is you still have exposure to a certain sector or asset class, but with reduced volatility.

The advantage is that, during a bear market, the equal weight ETF should experience a smaller decline than a cap-weighted ETF.  So you can swap out the latter for the former.  You may still see losses, but maybe not ones that are so devastating.

There are more aggressive methods to consider, however.  One of the ways to do this is to move into a short position.  One of my common trades is to short the S&P 500 using an ETF like ProShares Short S&P 500  (NYSE:SH). So, if the overall market falls, my short position will make money, offsetting losses in the long positions.

There are many other short ETFs available.   You can short the Nasdaq 100 with ProShares Short QQQ (NYSE:PSQ).  You can short the Russell 2000 with ProShares Short Russell 2000 (NYSE:RWM).

I also set a 7% stop loss, so that if the market suddenly recovers, I don’t lose too much on that shorting hedge.  You must be careful with shorts.

We aren’t in a bear market now.  However, the signs that the bear may awaken are out there.  The economic environment is weak. The Labor Force Participation Rate is at its highest level in thirty years, meaning more people have left the workforce since Jimmy Carter was President.  Q1 GDP was negative.  Although Q2’s initial number was positive, revisions are still to come.

Stay alert.

Lawrence Meyers does not own shares of any company mentioned.

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