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Saturday, October 10, 2015
How should you handle the risk of a bear market?
Assume for a moment that everything I've been writing about distress in the bond markets continues to get worse and eventually spills over into the equity markets and then into the general economy. If I'm right and we really are on the cusp of a massive wave of credit defaults all around the world, shouldn't you simply sell all of your stocks? Shouldn't you buy lots of put options and short dozens of companies? My answer will surprise you...
Longtime readers will remember my first bond-market warnings back in 2013. That May, I explained why the U.S. high-yield-bond market had gone completely "nutso" – yields on risky bonds were less than 5%, a rate of income that didn't protect investors from the inevitable default rate for bonds in that category.
In short, investors had bid up risky bonds so high that they no longer offered any real yield. Or as renowned newsletter author Jim Grant cleverly put it, instead of searching for risk-free yield, investors had begun to buy yield-free risk. I knew it wouldn't last. And I knew that sooner or later, there would be a calamity in that market.
To protect our portfolio, I suggested taking some profits. We sold seven companies – most of which had earned us good returns. On average, the stocks we "locked in" had produced annualized returns of 30% and average total returns of more than 50%. The truth is, you can't expect to make more money than that in stocks.
As you probably know... the markets didn't crash immediately. In fact, the high-yield-bond market retested its highs about 12 months later. Stocks, likewise, continued to march higher. And perhaps assuming that we suddenly couldn't read, our subscribers have gently reminded us of this fact – nearly continuously – ever since. Since we sold these stocks, on average, they've gone up 18%. On an annualized basis, they've gone up 8%. By selling, we avoided losses in only two of the stocks (Cheniere Energy and MGM Resorts).
You might not agree with me, but I'm satisfied with our choice. You're never going to sell precisely at the top. And you're never going to buy precisely at the bottom. You should handle your portfolio like an engineer handles a train. Most of the time, stocks go up. As a rule, your portfolio should be mostly "long." You should mainly be a buyer of stocks and bonds.
From time to time, of course, financial assets go down. Sometimes, they go down a lot. When that happens, it's awfully nice if your train is stopped (if you're in cash). It's even better if your train is in reverse (if you're "short" stocks on a net basis). What you shouldn't do, though, is constantly stop and start your train... or even throw it from forward into reverse.
I don't regret our caution. It's impossible to know exactly when the market is going to roll over. We took reasonable steps to protect our portfolio – to begin to slow the train down. We took our first few "stabs" at shorting the market. Buying insurance doesn't always pay off. But just wait... As the bear market develops, we'll continue to add more short exposure to our portfolio. It was our short recommendations that saved us in 2008. And they will save us again in 2016. When the cycle is finished, all of our shorts will end up being profitable, on average – including the losses we've taken so far.
We invest with humility. We use small position sizes. We use trailing stop losses. We know our timing is unlikely to be right on the mark, so we adjust our portfolio's orientation slowly.
If we had sold everything in June 2013 and gone 100% short, we would have lost a huge amount of money. Instead, we sold some stocks and took some profits. Meanwhile, we let our favorite investments and our best recommendations continue to compound. We've cautiously added "hedges" – short-sale recommendations and pairs trades. We're still waiting for the payoff from those choices, but they haven't cost us much.
Take our example to heart. If you're nervous about stocks and bonds like we are, sell some of your investments. Sell enough so that you can sleep well at night. Sell enough so that you will have plenty of cash if a crash occurs – enough to buy good investments at great prices. But don't feel like you have to sell everything. Don't pretend that you can know exactly when a bear market will begin. Likewise, when you're hedging your portfolio, try adding one or two shorts at a time. If they work, you can add more. If not, you know we're still too early. Remember: Most of the time, stocks go up. That's a hard trend to fight.
Date Range:10/1/2015 to 10/8/2015
Date Range:10/1/2015 to 10/8/2015