How to Earn 48% in a Bear Market

The dreadful returns we've witnessed since the start of the credit crisis -- the broad market lost 31% -- have put a huge damper on individual investors' enthusiasm for stocks. But what if I told you it was possible to earn a 48% return on a trade over that period?

That's 80 percentage points of outperformance! Better yet, what if I told you that during the (brief) periods when the trade was a loser, the loss never exceeded 7.3%, whereas the S&P 500 experienced a maximum loss of 55%?

Want to know more? Let me describe the trade, and then I'll go on to explain why there are similar opportunities in today's market.

Before the bubble popped
Back in early June 2007 -- at the top of the leveraged buyout boom -- there was only one publicly traded alternative investments group, Fortress Investment Group (NYSE: FIG). (Blackstone (NYSE: BX) would go public in the second half of the same month.)

Between the credit-fueled LBO bubble, strong growth in the hedge fund industry, and the scarcity value of Fortress' stock, I had a strong hunch investors were bidding the shares up to untenable levels.

A fine idea -- with one problem
At 22 times consensus earnings for 2007, Fortress shares looked expensive on an absolute basis and compared to its closest peers. The shares were ripe to be shorted, but there was one problem: I could see no obvious catalyst for a revaluation of the shares. (I hadn't predicted the credit crisis, which was the ultimate catalyst.)

Meanwhile, there was no reason that investors' exuberance couldn't propel the shares higher, brutalizing a short position.

A creative hedge
In order to mitigate that risk, I came up with a solution: Hedge the short position in Fortress with a long position in its closest comparable company, Goldman Sachs (NYSE: GS).

Besides its investment banking and capital markets activities, Goldman was one of the largest private equity and hedge fund managers in the world. At 10 times estimated earnings, the gap in share valuation with Fortress was striking. Assuming that gap were to narrow, investors could earn a positive return on the long-short pair regardless of the direction of the overall market, because what counts is how the two shares move in relation to each other.

Great success!
I wrote the idea up for the July 2007 issue of Motley Fool Inside Value (not as a formal recommendation, mind you), which was published on June 13, 2007. Since then, the market has proven out my thesis:

Source: Author's calculations based on data from Yahoo! Finance. These results do not account for dividends or margin fees.

It was a win -- but I would only ever recommend these stocks (Blackstone included) in the context of an opportunistic trade -- these aren't shareholder-oriented organizations.

Now before I break my arm patting myself on the back, I should point out that I didn't carry out this trade, nor did my write-up contain any indications regarding a time frame or return objective. All the same, it's one of the best trade ideas I've ever had.

Short low quality, buy high quality
Even so, a strategy of shorting speculative or overvalued stocks and hedging these shorts with long positions in higher quality stocks would not have worked out well so far this year. Oddly, lower quality names have outperformed their higher quality counterparts -- the "junk rally" we've witnessed since the market low of March 2009.

However, that has created a gap in valuations and expected future returns between lower and higher quality names that I believe will ultimately narrow in favor of the latter. In other words, there are similar opportunities in today's market.

Here are two pairs of stocks that look like fine candidates for the strategy I've described:

Source: Capital IQ, a division of Standard & Poor's. This is the stock return, not the strategy return.

I hasten to add that these are not recommendations -- I recommend you do your own research to see if you agree with my analysis of these companies.

Profitable investing in a bear market: The next step
Does this type of trade appeal to you? If you'd like to earn positive returns in a bear market and reduce the volatility of your portfolio, I think you'll be interested in John del Vecchio's free report "5 Red Flags -- How to Find the BIG Short." Most recently, as the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points. To find out more about how he achieved those returns and put a proven methodology to work in your portfolio, enter your email address in the box below.