It's hard to make money as a bear

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Down time
For the first time, I am an investment bear. I heartily dislike that status. I don't understand how to make money as a bear. It is far more difficult than profiting as a bull.

To back up: I do not believe that stocks have reached bottom. (This is my view, not Morningstar's.) After all, they have only recently begun to decline. Over the past century, no bear market exceeding 30% has ever ended after a single month. Sure, this downturn could be the first, but that is not how I would bet.

One problem is that willing sellers still exist. With stocks down so sharply, bargain seekers have entered the fray. Temporarily, they can support equity prices, sparking brief surges. Unhappily, such rallies are quickly squashed by those who close out their positions on uptick. The market will be better positioned to move forward when such investors are gone; but that process requires some time.

The other, more fundamental concern is that this bear market is like no other. To be sure, that statement is a cliche. No two bears are truly identical. This time, though, really is different. For example, Goldman Sachs forecasts that United States GDP will shrink by 24% in second-quarter 2020. If you think that sounds like a rather large amount, you would be correct. Since the Federal Reserve Bank of St. Louis' database started in 1947, the worst previous quarterly slump (in 1958) was by 10%.

Stock-market recoveries typically begin when investors believe that they have foreseen the worst. It lies ahead of them and therefore must be endured, but at least their worries are bounded. It does not seem to me that this downturn has yet reached that phase.

The tax man
The first concern for a newborn bear is taxes. Because stocks rise more often than they fall, bear-market investing tends to be tactical, thereby (if successful) generating short-term capital gains. In addition, some bear strategies require selling long positions, which, even after the recent stock plunge, are likely to be above their cost bases if the investor has held those securities for several years.

Any trades that incur taxes must be accurate indeed! For example, consider my position in Berkshire Hathaway (BRK.B), which closed on Friday at US$ 170. (Note: I drafted this column over the weekend, as my curmudgeonly editors dislike last-moment filings.) Its purchase price was US$ 70, and it resides in a taxable account, so selling that security realizes a tax bill. Nobody is smart enough to succeed while regularly paying a spread in the form of taxes. No columnist at least.

Path 1: Shorting
For those who can use such strategies in their tax-sheltered accounts--not possible with most RRSP plans--or who are willing to buck the odds with their taxable assets, how to invest? The historic answer has been to short stocks. Hold equities when you believe that they will rise. Borrow and then sell them when you think they will decline. That seems simple enough.

Simple, but terrifying. It's one thing to understand at a distance that while long holdings can lose only their purchase prices, short positions can lose everything. (No matter how wealthy you were, if you had the brilliant investment idea of shorting 1,000 shares of Berkshire Hathaway when Warren Buffett bought the company, and decided to maintain that short come hell or high water, you lost it all.) It's quite another to live through such an event.

I have not lived through such an event, though I have experienced one vicariously. I once read the tale of a portfolio manager who shorted Harrah's Entertainment stock after its 1971 initial public offering. Good call. By 1974, Harrah's traded far below its US$ 16 IPO quote. But it became a very, very bad call. Along the way, the stock rose to US$ 71, forcing the manager to close his position after meeting several margin calls. He lost both a small fortune and his wife.

Shudder.

Path 2: Cash
Rather then potentially lose it all, I could lose nothing by converting my equities into cash. (Setting aside tax implications, that is.) That wouldn't meet the stated goal of this article, making money as a bear, but it would at least avoid the problem of losing money as a bull, and it would position me well for the ensuing rebound. As the saying goes, I would have plenty of dry powder.

This, too, is a story I have read before. The corpses of dozens of market-timing and tactical-allocation mutual funds litter the industry's road. As a group, they were surprisingly good at avoiding downturns. Typically, they didn't exit the market early, but after absorbing a small beating, they would retreat, avoiding a large beating. They protected well against capital losses.

The problem came with capital gains. Inevitably, such funds were late returning to the market, often so late as to not return at all. Getting back into equities after raising cash is a psychologically difficult task. The investor misses the early part of the recovery while awaiting evidence that the rally is genuine; then, awaits a decline that will provide an attractive entry point; then (typically) waits even longer.

That is not a test I wish to take.

Path 3: Put options
For me, the most attractive bear-market option (so to speak) is buying puts. This tactic avoids the main drawbacks of the previous two approaches: 1) the unlimited loss potential of shorting, and 2) the portfolio disruption that comes from raising cash. When purchasing puts, one cannot lose more than the amount of the original investment, and, of course, that transaction is layered on top of the existing portfolio, rather than replacing it.

To be sure, buying puts in this fashion is a market-timing strategy, and market-timing is a difficult feat. However, as the mutual fund experience showed, timing is nevertheless easier than the follow-up task of determining how to get back into the market--a task that is not required when buying puts. The put buyer must get one decision correct, but not two.

Recently, I have considered employing this tactic for my portfolio, but I have not yet taken action. (Columnists are better at talking than doing.) Should I do so, it will be to hedge my equity holdings rather than to profit from further stock-market declines. Make no mistake: Such a trade would be speculative. But it would be speculative defense, not speculative offense. I would seek to survive as a bear, then profit as a bull.

Thoughts? Ideas? Send me a note at john.rekenthaler@morningstar.com.