Investment strategy for a bear market

If you believe a continued market downtrend for the intermediate term is likely, then shorting the market with exchange traded funds, stocks, currencies and gold might be of interest to you. But, warns Keith Richards, portfolio manager at ValueTrend Wealth Management in Barrie, Ont., be sure you fully understand the risks and rewards associated with these investment strategies.

Technical factors that I watch suggest this market is entering into a mid-termed bear phase. This bear phase could last a few months and take us down into the low 1700s on the S&P500. As I mentioned in my last column, a new leg in the bull market will eventually break out . . . but it may take several months to happen.

Breakouts need a catalyst – in either direction. I cannot see a positive catalyst to push the markets up from this point. Eventually, a bottom in oil may become that bullish catalyst. Further evidence of basing in oil is necessary before confirming that potential.

Given this bearish outlook, rallies should be sold, unless you have enough fortitude to withstand what could be a strong correction before the next bull phase begins. I don’t have such a strong stomach.

Should you feel a continued downtrend for the intermediate term it’s likely the investment strategies discussed below might be of interest.

To be clear–I will not be as thorough in this article as you will need to be if you truly wish to fully understand the risks and rewards associated with these strategies. I recommend you visit the websites for the providers of the ETFs (exchange traded funds) mentioned and read the prospectus before making an investment decision. As far as outright shorting a position, I also recommend you discuss the strategy with your brokerage firm or investment adviser to fully understand this investment strategy as ETFs mentioned are not suitable for everyone.

Inverse ETFs

In Canada, the only provider of this type of ETF is Horizons. They offer an inverse ETF that plays against the TSX (TSX─HIX) and the S&P500 (TSX─HIU). The relationship between the HIU ETF and the S&P500 index is -0.98 correlated, where -1.0 is a perfect negative correlation. Thus, at -0.98, HIU is pretty darned perfectly negatively correlated to the S&P500!

In order to help you understand the risks associated with inverse ETFs, I quote this excellent description from Wikipedia:

“If one invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value changes to $80 and then to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF’s value will be $100*1.20*1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However, if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.”

An investor in an inverse ETF may correctly predict the collapse of an asset and still suffer heavy losses. For example, if he invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value crashes to $1 and the following day it climbs to $2, then the value of the inverse ETF position will drop to zero and the investor would completely lose his investment. If the asset is a class such as the S&P 500, which has never increased by more than 12% in one day, this would never have happened.

Short ETF

The only true shorting ETF that I am aware of is that offered by AdvisorShares in the USA. The Ranger Equity Bear ETF (NYSEArca─HDGE) shorts a collection of stocks that the managers deem as having “low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period. In addition, the Portfolio Manager seeks to identify earnings driven events that may act as a catalyst to the price decline of a security, such as downwards earnings revisions or reduced forward guidance.”

An attractive feature of HDGE is that you are participating in a true short strategy without the unlimited loss potential of an outright short executed by yourself. Further, its diversification — often in about 40 stocks or so of the S&P500 listings — provides less individual security risk when compared to individual stock shorts. The fund not only utilizes a fundamental analysis approach to identifying the most overvalued stocks within the S&P500 index, it also incorporates a separate technical analysis overlay to look for the least technically attractive stocks within the fundamentally overvalued list.

Like HIU mentioned above, HDGE is almost perfectly negatively correlated to the S&P500 at -0.97.

Shorting stocks

Not all stocks can be shorted. Your brokerage must be willing to lend the stock to you to sell. You will be charged margin interest on stocks you short, which are executed through a specific short margin account. You will also be on the hook for dividends or rights issued during the time you are short the stock. Ideally, you will want to profit on the stock falling by buying the stock back at a lower cost than when you sold it after taking into account the various interest costs, dividends paid etc.

Should the stock go the other way (up) – you do have unlimited loss potential. Stocks could, theoretically, go up forever, assuming you hold the stock forever. Risk, therefore, is theoretically infinite on a short sale if you short a rising stock forever.

Another factor to consider on an individual stock short is the potential of short squeeze. Stocks in downtrends are often heavily shorted. At some point, somebody with serious capital behind them gets wise to the short volume and can “squeeze” the shorts by buying the stock, causing mass panic by the shorters to cover their positions. This ultimately results in a strong positive move for the stock, potentially causing a margin call or an unprofitable trade for you.

For this reason, if you really like the idea of shorting, I favour shorting an eligible market index ETF. Having said that, at ValueTrend we tend to focus on the above two strategies rather than direct shorting.

Euro and Yen

If you believe that the US dollar may be in for a bit of weakness as the Fed potentially backs down from its hawkish tone in late 2015, you may want to take advantage of a movement into currencies that are often negatively correlated to the USD.

The Euro can be bought through the Currency Shares Euro ETF (NYSEArca─FXE): As the European economies recover from the malaise that has hit them in recent years, I note that the Euro has been stabilizing of late. Given a potentially overbought US dollar, the Euro could benefit as a value play on world currency markets. I’m less interested in European equities than in the Euro itself – although this is not to say that I’m avoiding them.

Another currency that has been negatively correlated to the US dollar has been the Japanese Yen. You can trade this currency through the Currency Shares Yen ETF (NYSEArca─FXY). Should the Fed become more dovish (as might be expected), the Euro and Yen may outperform the USD.

Gold and gold stocks

Gold has returned to acting as a negatively correlated security vs. the stock market very recently. In other words, it zigs when stocks zag. I have noticed a possible basing action on the charts for this much unloved commodity—although at this point it is too early to be overly optimistic on its upside. In any case, I may execute short termed swing trades (in and out) in gold and gold equities to counter stock market volatility. iShares Global Gold Index Fund (TSX─XGD) is my vehicle of choice to play the gold stocks. To play the bullion, I’m looking at the Horizons COMEX Gold ETF (TSX─HUG) and iShares Gold Bullion ETF (TSX─CGL).