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%.

How things played out in the fund management industry
Out of 1,700 stock mutual funds tracked by The Wall Street Journal, only one managed to produce a positive return. That's because the huge majority of stock mutual funds are unable to engage in short selling because of their charter.

Industry numbers bear this out: In 2008, long/short equity hedge funds that simultaneously own stocks and sell other stocks short lost just 18%. (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.) 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", which was up 28%.

These figures should prompt the thoughtful investor to ask: in this new "bear" reality, where no one knows which way the market is heading, 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 from scrutinizing the 2008 performance of a screen-based investing strategy.

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 an abbreviated measure of which stocks are 'cheap' and which are 'expensive':

• Buy the stocks in the lowest 5% of the S&P 500 in terms of price-to-earnings ratio.
• Sell short the stocks in the highest 5% of the S&P 500 in terms of price-to-earnings ratio.

The screen produced 24 buy recommendations and 23 short recommendations. Here are a few selected positions to show how the strategy would have performed in 2008:

Long Positions

Source: Capital IQ, a division of Standard & Poor's.

Short Positions

Source: Capital IQ, a division of Standard & Poor's.

Following such a strategy for all 47 stocks would have produced these overall results:

Results

Fantastic! Following this 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 it's 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 revelry, 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 or slightly positive performance for the year and crushing the S&P 500 in the process.

In a bear market, hedged investing is vital
So there you have it: I don't have a magical algorithm that will guarantee gains in any market environment; however, I'm convinced that short-selling and related strategies are fundamental building blocks if you don't want to risk being mauled by the bear. The Motley Fool Pro team applies similar strategies in managing a $1 million real money portfolio. Because of the heavy volume of interest we've seen, Pro will be open to new subscribers only through tomorrow. If you are interested in finding out how to put these strategies to work to protect your assets, enter your email address below to receive an invitation to join Pro.