Daily Brief - How to thrive in a Bear Market

It’s official. We are in a bear market. Yesterday, still reeling from the awful inflation report on Friday, S&P 500 dipped into bear market territory. Actually, it didn’t “dip” - it literally plunged into it, head first. Now what?

A “bear market” in conventional investor-speak occurs when prices have fallen in value by more than 20% from recent highs. Check.

A full-on bear market shouldn't be confused with shorter-term corrections of a bull market because it’s usually caused by easy-to-spot fundamental changes in the macro picture: for example, runaway inflation … Check.

Anatomy of the Bear

Ok, so we’re screwed? Nope, not by a long shot. There are a few ways to thrive even in a bear market, and we’ll get to them soon - buying puts, 401(k), selling calls … But before we do, it's worth going through some basic lessons about trading in a bear market.

There was a really good book that used to make its rounds around trading desks during dark equity market periods like this one: The Anatomy of the Bear by Russell Napier. We highly recommend the book but we’ll recap some of key lessons about Bear Markets below.

1. Bears tend to die on low volume - A rise in volume on rebounds, falling volumes on weakness would mark a bottoming process in a bear market
2. Beware the Bear Traps - Fake rebounds are common: they suck investors back into the market only to ravage them again. Half of the S&P 500 Index’s strongest days in the last 20 years occurred during a bear market. At the bottom of a bear, you should hear great despair and a disdain for stock investing.
3. Bears can be tenacious - They refuse to die or, at the least, quickly return to hibernation. The average bear market has translated into a 38% price decline lasting an average of almost 19 months.
4. Bear Market damage can be inconceivable - Bear markets don’t lead to four year lows, they lead to ten year lows.
5. Not all Bear Markets lead the economy - A bear market doesn’t necessarily indicate an economic recession. There have been 26 bear markets since 1929, but only 15 recessions during that time.
6. Bear Markets are common - Assuming a 50-year investment horizon, you can expect to live through about 14 bear markets, give or take. Downturns have always been a temporary part of the process and stocks have been on the rise 78% of the time.

Survival strategies

Because bear markets aren’t uncommon, veteran traders rely on a number of strategies to make those periods less painful, or even downright profitable. Here are a few with limited downside risks:

1. 401(k) - Investing a fixed sum in stocks, whether through a 401(k) or a Roth IRA, you will end up buying more as market prices go down, improving your lifetime returns incrementally through dollar-cost averaging.
2. Hunting for dividends from rock solid companies - A dividend comes from a company’s net income and they are often very stable over time. As the stock price goes down, the yield you’ll receive for each dollar invested goes up.
3. Writing covered call options - That means you’re selling a call option against a stock you own. If the stock doesn’t rise to the option’s specified price during the life of the option (an option has a diminishing shelf life and an expiration date), then you’re able to keep both your stock and the premium from the sold option.

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