The Only Investing Strategy for a Bear Market

In 2008, the bear savaged investor wealth. The Dow Jones Wilshire 5000 Composite Index, the broadest measure of U.S. stock market performance, lost nearly $7 trillion in market value. The average stock investor lost approximately 38%. That's a difficult pill to swallow, but it's also the sort of jarring experience that should prompt the thoughtful investor to ask: in this new, "bear" reality, what works and what doesn't and, most importantly, how can I protect my assets against further losses?

Here's a hypothetical strategy
In order to answer that question, let me describe the lessons learned (or, rather, confirmed) from scrutinizing the 2008 performance of a screen-based investing strategy. The strategy rests on two legs:

• Buy the stocks in the bottom 5% of the S&P 500 in terms of price-to-earnings (P/E) ratio
• Sell short the stocks in the top 5% of the S&P 500 in terms of price-to-earnings (P/E) ratio (shorting a stock involves borrowing shares and selling them on in the hope that you will be able to replace them at a lower price later on -- it's a bet that the share price will fall).

It's a very basic implementation of two simple investment tenets: You want to own cheap stocks, and you want to sell (or sell short) expensive ones. In this case, I'm using the P/E as the basis for determining which stocks are "cheap" and which are "expensive."

The screen produced 24 buy recommendations and 23 short recommendations. Here's how the strategy would have performed in 2008 (assuming equal dollar amounts invested in each position):

Long positions (selection)

*Price-to-trailing-12-months' earnings before extraordinary items. Source: Capital IQ, a division of Standard & Poor's.

Short positions (selection)

*Price-to-trailing-12-months' earnings before extraordinary items. Source: Capital IQ, a division of Standard & Poor's.

Results (summary)

Fantastic! Following our strategy, we would have a suffered only a minor capital loss in a brutal bear market, coming out well ahead of the S&P 500. Have we uncovered "the only strategy for a bear market"? Unfortunately, no.

It's not that simple
To prove it, let's imagine that we are at Dec. 31, 2007. We have just finished running our screen and we have our two lists of stocks (high and low P/E) that we're going to transact in. However, distracted by the thought of the evening's New Year celebrations, we mix up our list of buy and short sale orders; instead of buying the low P/E stocks and selling short the high P/E stocks, we buy the high P/E stocks and sell short the low P/E stocks.

Disaster! We've implemented the exact opposite strategy to the one we wanted to follow. What are the results? Perhaps surprisingly, we would have ended up doing better than the "correct" strategy, achieving a positive return of 3.8% in 2008 (over 40 points ahead of the S&P 500)!

The opposite strategy "worked," too!
If a strategy and its opposite both beat the market, we can surmise that it is the product of two factors:

• A shared characteristic of the strategy and its opposite
• The market environment

The mystery first factor should be evident: although the specific stock names were switched, in both cases, the long positions are nearly evenly balanced (in number) with short positions. The shorts were the key to turning in a slightly negative/slightly positive performance for the year -- crushing the S&P 500 in the process.

How things played out in the fund management industry
Industry numbers bear this out: In 2008, Long/Short equity hedge funds (funds that simultaneously own stocks and sell other stocks short) lost 18.3%. Not a glorious performance, to be sure, but well ahead of the major indices. Not surprisingly, the best-performing hedge fund strategy last year was "short bias," up 28.3%.

At the other end of the spectrum, out of 1,700 stock mutual funds tracked by The Wall Street Journal, only one managed to produce a positive return! (The huge majority of stock mutual funds are unable to engage in short selling due to their charter.) In a bear market as severe as the one we are in now, there is nowhere for "long-only" investors to hide. The market's downward tide is absolutely overwhelming … unless you have the foresight to move your assets into cash (very challenging) or use short selling or other hedging techniques.

Moreover, the stakes are sizable: Avoiding losses is critical to satisfactory long-term returns because of the asymmetry between investment losses and investment gains. Remember that in order to erase a 40% loss to his or her portfolio, an investor must subsequently score a 67% investment return.

In a bear market, hedged investing is vital
So there you have it: I don't have a magical strategy that will guarantee gains in any market environment; however, I'm convinced that short-selling and related strategies are fundamental building blocks if you want to avoid being mauled by the bear. The Motley Fool Pro team applies similar strategies in managing a $1 million real-money portfolio. If you are interested in finding out how to put these strategies to work to protect your assets, click here to receive a limited-number invitation to join Motley Fool Pro.