With the S&P 500 Index near a new all-time high — and the near-continuous beat of bad news — it’s reasonable to believe that a significant pullback is coming.
These facts make many investors nervous. Some may want to act. A common question is: “What can I do to avoid losses in a bear market?”
Well, there are several possible actions — that each come with pitfalls you want to avoid.
Investing in a Bear Market Isn’t Easy
One simple strategy many investors follow is selling stocks and holding cash. Then they buy stocks after the bear market.
Risks of this strategy include selling too early and missing out on gains, or buying stocks back too soon and suffering losses as the bear market continues.
Another strategy is to buy put options. Puts increase in value as stock prices fall. In theory, put options allow investors to maintain exposure to stocks while limiting their downside risk.
Unfortunately, this strategy is expensive. Put options on the SPDR S&P 500 ETF Trust (NYSE: SPY) that expire in December cost about 10% of the price of the exchange-traded fund (ETF).
But this also means you can limit the maximum loss of your portfolio to 10%. And if the broad market declines 20%, gains from the puts could offset those 10% losses.
A risk of this strategy is that there may be no pullback. In that case, you could lose 10% of your portfolio.
A third strategy is inverse ETFs, which go up in value when the value of the index drops.
This strategy also carries risk. Inverse ETFs are rebalanced daily. That means they can lose money if the market declines in the wrong sequence.
In the bear market that ended in 2009, there were several examples of inverse funds losing money in falling markets.
The table below shows two examples of inverse ETFs failing to match their objectives. A 2X inverse fund seeks to move twice as much as the underlying index every day.
As the table shows, for emerging markets, the inverse fund should have gained more than 50% based on the expectation that it moves opposite the benchmark. It gained less than half that.
The leveraged ETF that seeks two times the daily gain lost money in the bear market, while the naive expectation would be for a gain of more than 100%.
Inverse oil and gas stocks did even worse. Just like the index, the inverse and the leveraged inverse funds lost money.
The Best Way to Trade a Market Decline
This shows the difficulty of a long-term bear market strategy. When it comes down to it, there simply isn’t one that’s entirely reliable.
The best strategy may be to actively manage trades during the decline. This will allow investors to adapt as market conditions change.
If you’re not sure how to do that on your own, I recommend One Trade, my trading service that provides active management in any environment … including bear markets.
Michael Carr, CMT, CFTe
Editor, One Trade