This post is about how to invest in a bear market. This post is about how to trade in a bear market.
Bear markets are wonderful opportunities for medium-long term investors. The more overvalued a market becomes during a bull market, the greater the market’s long term downside risk. Bear markets cut valuations significantly. This means that:
- The market becomes much cheaper and a much better long term BUY after a bear market bottoms.
- The market’s long term downside risk is smaller because the market is already undervalued.
So how should medium-long term investors invest in a bear market? Here are some common bear market investing strategies, ranked from worst to best.
- Sit right through a bear market while being 100% long.
- Shift into defensive sectors
- Shift to long term Treasury bonds
- Buy inverse ETFs.
- Shift to 100% cash
- Shift to short term Treasury bonds
Let’s look at each of these investment strategies in detail.
Sit right through a bear market while being 100% long.
This is the worst bear market investing strategy ever. Period. Financial services companies tout this because they need to generate commissions even during bear markets.
Some investors convince themselves that they are “long term investors” who don’t care about bear markets. They convince themselves that “all dips are meant to be bought because the stock market goes up 7-8% over the long run”.
They are lying to themselves. Most of these perma-bulls lose their composure and sell AFTER stocks have already crashed 40% in a bear market. In reality, investors should avoid bear markets like the plague. Can you imagine losing 40% of your entire networth in a little more than 1 year? (Leveraged ETFs would lose 90%+ of their value). It would destroy you psychologically.
Bear markets aren’t rare. They’ve happened 4 times since 1950 and 6 times since 1929. In other words, every generation will see at least 2 bear markets in their life time.
Each of these declines were massive: 40%+. The stock market takes YEARS just to recover to old all-time highs after a bear market. Long term investors who ignore bear markets are underwater during that entire time. Imagine holding a massive loss for 5 years. It’s financially and psychologically devastating.
Here’s the S&P 500 during the 2008 bear market.
And here’s the thing. You cannot blindly trust that a normal bear market will just end. The 1929-1933 bear market saw the S&P 500 and Dow Jones fall 90%+! The reality is that another 1929-1933 event could happen again. It’s not likely, but it is a possibility. Imagine losing 90%+ of your hard earned money.
Shift into defensive sectors
Some investors shift from high growth sectors like tech to defensive sectors like utilities during bear markets. Defensive sectors move less than the S&P 500. This means that if the broad index goes up 1%, defensive sectors might only go up 0.5%. If the broad index goes down 1%, defensive sectors might only go down 0.5%.
The thinking behind this bear market strategy goes:
- I won’t be sitting on the sidelines if a bear market DOES NOT occur. At least the defensive sector (e.g. utilities) will go up with the rest of the stock market, even if it doesn’t go up as much as the rest of the stock market. So I will still participate in some of its gains.
- I won’t lose as much money as the average investor if a bear market DOES occur. Defensive sectors fall less than the broad index in a bear market.
This strategy doesn’t make much sense. Most investors get killed by bear markets. Investing in defensive sectors during bear markets merely ensures that you don’t get 100% killed. Maybe you’ll only be 70% killed. There’s not point in investing on the long side if you truly believe that a bear market is imminent.
Remember, you don’t always have “in the market”.
Shift to long term Treasury bonds
Some investors like to shift into long term Treasury bonds when it’s a bear market in equities. This way:
- They earn some interest from the bond while they’re holding the bond.
- Interest rates usually go down a little during equities bear markets. This means that the investor is earnings a capital gains when he/she sells the bond at the bottom of the equities bear market.
This strategy works most of the time, but not always. Sometimes interest rates RISE during an equities bear market and economic recession. For example, the 10 year Treasury yield went up during the 1969-1970 and 1973-1974 bear markets.
Buy inverse ETFs
Some investors buy inverse ETFs during bear markets, hoping to profit from the market’s decline. This is a good idea, but only if you have an extremely accurate way of catching the bull market’s exact top and the bear market’s exact bottom.
Other investors try to amplify these profits by buying leveraged inverse ETFs. This is not a good idea. Inverse ETFs are meant to be traded. They are not meant to be held as long term positions during bear markets.
ETF erosion is generally a bigger problem during bear markets than in bull markets. This means that erosion can have a detrimental impact on leveraged inverse ETFs during bear markets.
Here’s XLF, the financial sector’s long ETF. Notice how it made a new low from October 2008 to March 2009.
Here’s SKF, the financial sectors 2x leveraged inverse ETF. Notice how it didn’t make a new high from October 2008 to March 2009. This is due to ETF erosion.
Shift to 100% cash
This is a good strategy for investing during bear markets. You don’t always have hold a position. Sitting on 100% cash and making $0 IS MAKING MONEY when everyone around you is losing money during a bear market. Becoming richer/poorer is a relative term.
Shift to 100% cash when you expect a bear market to start. Shift back to 100% long only when you think that the bear market is over and that a bull market is about to begin.
Shift to short term Treasury bonds
This is a good investment strategy that I might use during the next bear market. Bear markets usually last at least 1-2 years. This means that you can:
- Sell all your stocks when you think an equities bear market is imminent.
- Shift to 100% long short duration Treasury bonds, such as the 2 year Treasury bond.
- Earn money from the interest on those bonds.
- Once the bond matures, use the proceeds and wait for the bottom of the bear market.
- Shift back to 100% long at the bottom of the bear market.
The ONLY risk with this is the very small possibility of a U.S. government default.