I was talking to a 67-year-old woman who is close to retirement and wanted me to review her financial portfolio. She has a money manager with a well-known full-service brokerage firm. She was upset because she lost $30,000 in the last month. When I looked at her portfolio, I was shocked. The money manager had her 100 percent in stocks. Whenever she asked him to reduce the allocation, he protested: “It’s not a real loss until you sell,” he told her. Hogwash.
To stop the bleeding, she finally got the courage to sell all her stocks and move into cash (i.e. money market) until she finds another financial manager. Good move. In a bear market, most stocks, even stocks of good companies, will sustain severe losses. The market might go down by 20 percent but many individual stocks will go down by 40 or 50 percent. This is not going to end well for millions of people who own individual stocks. If you’re close to retirement or retired, in my opinion, you should be reducing the number of stocks in your portfolio.
By now, most investors and traders know what happened to LinkedIn (LNKD). After the company reported earnings, the stock plunged by 40%, smashing the portfolios of pros and amateurs alike. LinkedIn has a history of booms and busts after announcing earnings. In the future, before any stock announcement, there are two actions you might consider:
- If you are long a stock, you can buy short-term (weekly) put options for insurance. If the stock plunges (as happened in this case), the put options would reduce (but not eliminate) the pain. The downside is that puts on some volatile stocks are pricey, especially if you choose a long expiration date.
- Instead of being exposed to a large and expensive stock position, replace the stock with call options before a major news announcement (assuming you are long the stock). With LNKD, although you would have lost the entire amount of the cost of the option, instead of losing a small fortune, you may have lost a small amount. Example: Instead of losing $8,000 with 100 shares, you might have lost $400, the total cost of the option.
In a bear market, put options are your friend. Use them for protection or for speculation. For more information, read my book, Understanding Options 2E (McGraw-Hill).
During the next few weeks and months, I think it will be evident we are in a bear market. Some of the most recent signs are the many failed rallies as well as a lack of follow-through (i.e. rallies that don’t last longer than a day or two). If this is a typical bear market, it can last from 18 months to three years, which means it could end in 2017. If I’m right, you have several choices of what to do (you can also read my interview with Mark Cook for his suggestions: http://goo.gl/JX1zQP).
Here are some other ideas:
- First, you have to be objective. Many investors are bullish simply because they own stocks. If underlying market conditions continue to deteriorate, and stocks continue to fall over time, don’t fight reality but accept the market is in a downtrend. Many investors will deny the existence of a bear market until they’ve already lost 30% or more of their position. Before the media announces we’re “officially” in a bear market, take steps now.
- Most investors believe they can “ride out” the bear market because they are thinking long term. That is a very courageous stance but I guarantee that some individual stocks will not survive a vicious bear market. If you are going to grit your teeth and hold through an extended downtrend, you’d be better off holding an index fund such as the S&P 500 than holding stocks. Be prepared for months or years of pain before the index recovers.
- The easiest choice is to move most of your money to cash. For some reason, most investors won’t do this, and most money managers won’t, either. As for me, I’d rather make 0% in cash than lose 30% or more in a bear market, but that’s me. I know I’m in the minority.
- For those willing to learn how to trade, buying and holding inverse ETFs (non-leveraged) can be a wise choice. Keep in mind that bear markets do end eventually so you cannot hold these funds indefinitely. You must be willing to sell your inverse funds when there is a bottom, usually when bullish investors give up and capitulate. You have to be patient and alert to identify when a bottom has been reached and the market is headed up again. Look at what happened to oil and gold. Eventually, oil and gold will hit bottom and head higher. Stocks could take a similar path.
- For aggressive traders, buying put options in a bear market can be lucrative if you are disciplined and knowledgeable. I recommend buying my book, “Understanding Options 2E” if you want to take this route. Buying options is less risky than shorting stocks, but there is still the risk you can lose your entire investment. Because of leverage, buying put options in a bear market and call options in a bull market can increase gains dramatically. However, it’s easy to make and then lose money trading options if you are not alert. Trading options can be intense, and when holding them you sometimes feel like you’re playing a game of “hot potato.” That’s why I always recommend selling options quickly when you have a substantial gain.
Soon, you should see more signs that we are in a bear market (the pivot point was actually several months ago). With each failed rally, continued deterioration of leading stocks, and false hope that the worst is behind us, it will become more evident that the bear has arrived. If you want to learn more about bear markets, read everything about trader Jesse Livermore, who was an expert at trading in downtrends. Mark Cook is also an experienced bear market trader, and there are others including Bill Fleckenstein and John Hussman, to name a few.
If you have a money manager, this is the time to find out what he or she is doing to protect your account. A few months ago, one money manager wrote me, “If there is a bear market, I will sell stocks that are going down and buy stocks that are going up.” If only it was that easy (but it’s not). Trading bear markets are difficult for most investors, including most pros, as you will soon find out. You could also take the advice of a guest on one of the financial programs: “People, my advice is simply not look at your monthly statements!” this person suggested. Oh, okay, and when you wake up in two or three years, Humpty Dumpty will be put back together again and all your losses will magically turn into gains.
Bear markets are not fun for most investors and believe me, I’ve seen people ruined by them. Rather than burying your head in the sand, come up with a plan and strategy and make a decision what to do. If you’re a long-term investor, you’re hoping the bear market will last a few months, not years. Suggestion: Prepare for a worst-case scenario.
Last weekend I interviewed Mark Cook about the bear market he saw looming a year ago. As many of you know, I also saw signs of a dangerous market, and in January, the market got rather violent. Here is a link to my MarketWatch interview with Cook. I hope you enjoy it!
As for me, I’ve been busy trading this market. Although there are no guarantees it will work in the future, shorting the rallies using put options has been working (but even in a bear market, there are wild rallies). This strategy is for active traders who have the time to monitor their positions during the day. If you don’t have the time or ability to trade, moving all or some of your money to cash is the safest idea. As you may know, many disagree that you should sell stocks and move to cash. Only you can decide what is best. Meanwhile, be careful out there. Many stocks are going to be taking big haircuts.
Although I anticipate that the bears will have a strong showing this year, I have learned to wait for the market to confirm my view. If the market starts to plunge, I will add to my inverse ETF positions, and also buy puts for the short term. Don’t forget Jesse Livermore’s astute observation: Only the market is right. Put another way, don’t think you are smarter than the market. Many billions of dollars have been lost over the years because investors and traders refuse to admit that the market has the final word.
As a long-term trader, I strive to be patient enough to wait for the right opportunity, and agile enough to pounce at the right time. If I’m late, I will not play catch-up but will be patient enough to wait for the next opportunity. Got that? Don’t chase if you missed an opportunity to make money. You will get another chance a day, week, or month later depending on market conditions.
My favorite book in 2015: Jesse Livermore — Boy Plunger by Tom Rubython. Highly Recommended.
I also recommend Prepare Now and Survive the Coming Bear Market by Mark Cook and myself. It appears as if a bear market has arrived, and our book will tell you what to expect.