How to Protect Yourself in a Super Bear Market

By Van K. Tharp, Ph.D.

If youíve read my book, Safe Strategies for Financial Freedom, you should understand that we are still at the early stages of what could be a Super Bear Market.  That bear market started in 2000 and will probably end sometime between 2015 and 2020.  And while itís difficult to predict what the market will do in a year, we can predict that if you have a long stock position that you just hold, youíll lose much of those assets by the time this bear is finished with you.

How do we know this occurs?  Basically in the last 200 years, the market has gone through such cycles, repeatedly.  Why should it be different now?  Furthermore, the cycles tend to have a huge psychological component.  At the end of the last secular bull market in 1999, everyone was playing the stock market.  Everyone was a a stock market geniusóthe waiter at your restaurant, the bartender at the same restaurant, and even the taxicab driver who picked you up.

However, you might be thinking that we already had three rough years in the stock market from 2000-2002, so perhaps the market is now on its way to recovery.  No, thatís not the case at all.  This bear market will be over when everyone is totally afraid of the stock market.  Hereís what youíll probably see:  

  1. many mutual funds will close down because theyíve lost heavily; 
  2. pension funds will no longer be allowed to invest in the stock market because they consider the risk too great; 
  3. very few of my clients will be equity investors (i.e., theyíll all be into options or futures or Forex.); and
  4. most importantly, stocks will be at all time bargain levels.  

Blue chip stocks will be paying dividends of 5-6% and have single digit price earnings ratios.  When you see that youíll know that the bear market is over.

How Can You Protect Yourself?

In Safe Strategies for Financial Freedom, you learned several strategies to protect yourself and even profit on the way down.  These included the bear market mutual fund strategy, the shorting stocks strategy and the Grahamís Number strategy to use as when prices start to get low.

Weíve also provided you with a 1-2-3 model, which gives you a general idea what to expect within the next year from the stock market.  When it goes to red light mode (which it is in right now), you can expect stocks to fall on the average about 10% per year (but thatís an averageóit could be worse or it could be much less).

What If You Absolutely Have to Own Stocks?

Letís say you own a lot of your company stock and you need to keep that for some reason.  You might be a senior executive and perhaps you feel it wouldnít look good to sell your stock or perhaps you cannot sell it or youíd lose control over the company.  Perhaps your stock is expensive, but your basis in your stock is only $1, so youíd have a large tax consequence (this is a very poor excuse for hanging onto a stock but many people use it).  You might have any of these, or numerous other reasons, for hanging onto a large holding in some stock.  What do you do?  You donít want to lose 70-90% of its value.

Mark Cuban was such an individual.  He was an Internet entrepreneur, one of the founders of Broadcast.com.  Mark, however, was lucky.  His company was bought out by Yahoo! near the peak of the Internet bubble for $56 million worth of Yahoo! stock   Although I donít know all the details of the transaction, this was probably close to the time that Yahoo! was worth $240 per share, but during the 2000-2002 crash Yahoo! dropped about 95%.  When your company is bought out by another company, what you usually get is restricted stock that will not allow you to sell it for a certain period of time.  Had Mark Cuban not been very smart, he could have ended with Yahoo! stock that was worth $2-3 million.

But Mark Cuban started employing sophisticated options strategies.  He had put and call collars around his stock.  And the net results is that heís still a very wealthy man and he still owns his stock.  Heís also the proud owner of the Dallas Mavericks.

You can do the same thing.  For example, if you are convinced that the stock you own is going to start falling big time (e.g., its in a downtrend and we are in red-light mode), then you can create a synthetic short position.  The net result is that you stop losing money.  And when the stock stops falling, you can unwind your synthetic short (or convert it to something else) and pocket a lot of money.  And youíll still own the stock.  Wow.

Sophisticated options traders know how to do that and you can too.

What About Gold Stocks?

If  we look at the big picture, the United States has a huge debt (over $35 trillion dollars) a huge balance of payments problems (over $50 billion each month), and we are facing a situation in which the elderly could have bankrupt pension plans and bankrupt social security.  Read Safe Strategies for Financial Freedom to understand this better. 

What can we expect?  If the situation keeps going, other countries will not want our dollar.  Thus, we can expect the dollar to go down in value.  In case you donít know, the dollar declined 40% in value against the Europe at the same time the stock market was falling.  Thus, even if you didnít have money in the stock market, you still lost 40% of your wealth if its based on dollar denominated assets.  

In addition, the best way for a country to handle massive debt is to inflate the value of the currency.  The Federal Reserve has basically said that this would be their policy.  And we usually consider 2-3% inflation to be acceptable.  However, as the debt gets worse we might have to revert to massive inflation that would simply make the debt become worthless.  Thatís certainly one solution.

Anyway, both of these scenarios suggest that you should own gold stocks.  

How Do I Do It?

Iíd like to caution all of you that 90% of all option trades lose money.  Donít just buy options.  You might hear about the extreme leverage and the limited risk in options.  Thatís true, but most people just donít have the knowledge to trade options adequately and then end up losing money.  And most options workshops that promise fast profits quickly simply show you the potential leverage with buying options or the protection you might get with covered calls.  And the latter is especially dangerous in this market because it is equivalent to writing a put option.  That means you have limited upside profit, but if the stock drops heavily youíll lose big. 

Instead, what you need to do is to educate yourself about options.  You need to learn how to price options without a computer, how to tell what an option is really worth just by looking at it and how to use all sorts of sophisticated strategies to protect your positions.

About the Author: Trading Coach Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his classic Peak Performance Home Study Course for traders and investors. Visit him at www.iitm.com for a FREE trading game or to sign up for his FREE weekly newsletter. 

 

 

 

 

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Last revised: January 27, 2010