We are now in the late stage of a mature share bull market worldwide. The bull market started in around 2009 after the sharp GFC selloff and the duration is thus above average. After a year of very low volatility more normal volatility with sharp selloffs is now becoming the norm. European share markets are particularly weak and they will be the first ones to roll over into a bear market. Eventually other markets in Asia, Australia and the US will follow – as they always do.
When share markets go into a bear market they will usually retrace around 30 % from previous peaks and sometimes even more as we have seen in the GFC (- 50 % +) or the Dot.Com bubble in the NASDAQ in 2000 (- 70 % +).
As markets move from overall rising prices (bull market) into overall falling prices (bear market) prices of the major indices such as the ASX 200 or the S&P 500 will start trading below a flattening and then falling 200 Day Simple Moving Average (200 DMA). In a bull market the rising 200 DMA will act as support where prices bounce off; in a bear market the falling 200 DMA will act as resistance that prices usually cannot penetrate.
So what is the investor to do when markets start rolling over into a bear market? Well, we have basically three options:
Option 1: Do nothing
That’s what the ‘Buy and Hold’ advisor camp tells you to do. They tell you that time in the market is more important than timing the market; that timing the market cannot be done and that share markets have a long term upside bias and eventually will go up again. And I agree: If you look at a (very) long term chart prices tend to rise overall. If you follow this advice you will have to be able to handle a 30 % + losing period (called drawdown) in your portfolio. That is just normal. During this time you still will get dividends and eventually your portfolio value will reach its previous peak. But the time to recovery can sometimes be 10 years; 10 years where you have no capital appreciation whatsoever. If this happens to you at the beginning of your retirement where you have the double whammy of a loss of 30 % + in your portfolio and a prolonged period of no return your retirement lifestyle will most likely suffer. As an active investor option 1 is not for me.
Option 2: Go into cash
As the markets roll over, the 200 DMA is flattening and then falling and share prices or share price indices trade below a falling 200 DMA, it is high time to liquidate share positions in your portfolio and realise well earned profits of the previous bull market. Most likely your latest purchases will be closed out with a minor loss but this is not the end of the world. After you have sold all (or the vast majority of) your shares you can put your money into cash and earn a low but risk free interest barely beating inflation. The purpose of this strategy is not really to make money (you won’t) but rather not to lose any money and to be cashed up. The average bear market lasts 12 to 36 months (where you have low but at least not negative returns) and being in cash during this period allows you to pounce and build up share positions once the share market bottoms and provides again buy signals. This is a relatively simple strategy and does not require much work. You just follow your share holdings and overall market indices and liquidate if and when an individual share or a relevant share price index trades below a falling moving average. Option 2 is already way better than doing nothing and staying fully invested in a bear market.
Option 3: Go short
Most investors know how to make money in shares: Buy low – sell high. And usually they do the buying low BEFORE they do the selling high, the normal and in most investors’ mind the only way to make money. But there is another way, called ‘shorting’. As an investor you still buy low and sell high but you do the selling high before you do the buying low. With regards to shares or ETFs (Exchange Traded Funds) you will have to borrow the instrument sold short via your broker as the buyer – paying you good money for the shares wants you to deliver the shares. Your broker will access a pool of shares held by long term investors, i.e. institutions. They will lend you the stock under the condition that you will eventually return the shares and that you will compensate them for the lost dividends as the new owner of the shares is now entitled to all dividend income. The idea is to short sell the weakest shares and buy them back once your exit conditions (buy back conditions) are met. Usually your shorting trading system will be the opposite of your buy strategies.
In Australia, the easiest way to do this is via a CFD – a contract for difference. This is a margined product where the trader only has to deposit a small good faith deposit, called margin, usually 10 %, with the broker with all unrealised profits credited to the account and all unrealised losses debited to the account. The trader can maintain the position as long as there are sufficient funds in the account to maintain the required margin. A moderate leverage is quite welcome as it increases the potential return (but it also increases the risk associated with the trade). I would usually limit the leverage to 2 to 1 or 3 to 1, i.e. I would fund a let’s say $30,000 position with $15,000 (2 to 1) or at least $10,000 (3 to 1) cash. I believe that a super fund should be traded more conservatively and I would be reluctant to use leverage in such an account.
Instead of shorting individual shares (as a CFD) the investor could also short ETFs also as a CFD. There are many ETFs listed on the ASX and above all in the US and most can be readily shortened. The investor has the choice to short specific country ETFs, ETFs on a region (e.g. Frontier markets), on a specific sector (e.g. consumer durables), bonds or various metals.
An alternative to shorting specific country indices via an ETF would be to use a futures contract on a country share price index. The futures contract on the ASX 200 is the SPI; futures contracts on other indices are the DAX (Germany), CAC 40 (France), Nikkei (Japan) and the US e-minis (mini contacts accessible for private investors) such as the e-mini S&P 500, the e-mini Dow Jones Industrial or the e-mini NASDAQ. Futures contacts usually expire quarterly and are cash settled. Close to expiry the investor will have to close out (i.e. buy back) the short futures contact that is about to expire (front month) and initiate a new short on the new contract (back month). This is called ‘rollover’ of a futures contract. Futures are margined like CFDs with the margin even lower (usually around 5 % of face value) providing potentially even higher leverage. Again leverage should be held at reasonable levels or in the case of a super fund totally avoided.
Option 3 provides the possibility to make money in falling markets, exactly when the long term buy and hold investors are losing money. It is another strategy in your investment repertoire. It does, however, require somewhat more work as you would have to follow the markets all the time and track your positions. A major advantage of this strategy is that you are more likely to catch the beginning of a new bull market ready to reverse your positions from short to long.