“The bull walks up the stairs. The bear jumps out the window.”
– Wall Street adage
The CNN Fear & Greed Index – my favorite measure of market sentiment – has been all over the place this year.
The index plunged to “extreme fear” after the coronavirus market crash in March. But just earlier this month, it was in “extreme greed” mode. And now it’s back to “neutral.”
Professional investors know that sudden drops are inevitable.
Still, the suddenness and sharpness of pullbacks always seem to take the average investor by surprise.
In contrast, seasoned investors know that it’s not what happens in the market that matters… but how you react to it.
How to Prepare for the Worst
A sudden shift in investor sentiment highlights why you need a strategy for when a bear market inevitably arrives.
Below are three bear market strategies you should consider today.
No. 1: Set Trailing Stops
Warren Buffett has endured drawdowns of close to 50% three times in the past: once in the early 1970s, once in 1999 and again during the 2008 financial crisis.
Buffett has warned that if you can’t endure a 50% drawdown in your portfolio, you shouldn’t invest in the stock market.
Easy for Buffett to say!
Given the size of his positions, Buffett has no choice.
For the rest of us, a bear market means “buy and hold forever” becomes “grin and bear it.”
Luckily, as a small investor, you have a massive edge over Buffett in your ability to sell.
The Oxford Club has a simple rule: Set a 25% trailing stop on your investments unless we tell you otherwise.
Implementing this one rule will do wonders for your long-term returns – and psychological health – when the bear market does arrive.
No. 2: Bet Against the Stock Market
In the past, I’ve compared exchange-traded funds (ETFs) to Lego blocks, which allow you to build, brick by brick, a portfolio to fit your specific investment objectives.
A good example of a relevant ETF strategy is inverse ETFs.
Inverse ETFs are bets against the market. That means they go up when the market goes down.
Say you’re convinced tech shares are set to crash. You can bet against the Nasdaq 100 by buying the ProShares Short QQQ ETF (NYSE: PSQ).
If the index drops 10%, this ETF will rise by the same amount.
There are even leveraged versions of this short bet. Invest in the ProShares UltraShort QQQ ETF (NYSE: QID), and when the Nasdaq 100 drops 10%, the fund will jump around 20%.
Finally, the ProShares UltraPro Short QQQ ETF (Nasdaq: SQQQ) offers triple-short exposure. A 10% tumble in the Nasdaq 100 could generate up to 30% returns.
Invest in inverse ETFs at the right time, and not only will you not have to worry about the market going down but, if you get your timing right, you can make more money, more quickly, once that bear jumps out the window.
No. 3: Bet on “Black Swans”
Popularized by my friend Nassim Nicholas Taleb, a “black swan” is a rare, high-impact, unexpected event.
In investing, black swans happen when financial markets fall fast and hard. (Think of the crash of October 19, 1987.)
These sharp falls occur far more often than option pricing models predict. A black swan always comes out of the blue.
So how to best protect your portfolio?
You could engage in a complex range of options strategies like Taleb does.
Or you could just buy an ETF that implements an options strategy for you.
Specifically, the Cambria Tail Risk ETF (CBOE: TAIL) invests about 5% of its assets in a portfolio of out-of-the-money put options on the S&P 500. It holds the rest of the assets in 10-year U.S. Treasurys.
Both Treasurys and put options tend to rise during a market crash. But like any other form of insurance, this protection costs money.
Cambria spends roughly 1% of the fund’s total assets purchasing put options over rolling one-month periods, so this “insurance” costs you about 1% per month.
How has this ETF fared during market corrections?
Pretty much as advertised.
In the first quarter of 2020, the S&P 500 tumbled around 23%. Over that period, the price of the Cambria Tail Risk ETF rose by just about the same amount.
The bottom line?
Whether a pullback is market jitters, a correction or the start of a bear market… always make sure you have a plan in place for a bear market.