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The fearful investor's to-do list: five ways to not be eaten alive by the bear

Kiplinger's Personal Finance Magazine, Sept, 1998 by Manuel Schiffres

Five ways to not be eaten five alive by the bear.

Let's not mince words. A bear market--a drop in the major stock indexes of at least 20%--is on the way. Admittedly, nobody knows just when the beast will arrive. It could be next month or the next millennium. To be sure, the optimistically challenged can list plenty of reasons for anticipating an imminent downturn. To name a few:

* Sky-high prices Standard & Poor's 500-stock index yields a record-low 1.4% and sells at a record 30 times the previous 12 months' earnings.

* Slower profit growth. This is due, at least in part, to the economic implosion in Asia.

* Bad breadth. Fewer stocks have been leading the market higher.

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* Excessive speculation. Just look at Internet-related stocks.

The fact is that by traditional standards the market has been overvalued for years. But high valuations by themselves have rarely been the cause of bear markets, although they do suggest that risks are high. Suppose you have a strong conviction that the bull's days are numbered but don't know what to do about it. Here are five ways to protect your gains.

REBALANCE YOUR PORTFOLIO. This common-sense rule for managing your portfolio is too often ignored. If you once intended to keep, say, 70% of your assets in stocks and the rest in bonds or cash, your stock allocation is probably much higher now. Sell enough stocks to bring your asset allocation back to the desired proportions. This maneuver and others that involve selling appreciated shares are best done in tax-favored accounts, such as IRAs or 401(k) plans.

LOWER YOUR STOCK ALLOCATION. You can go beyond just rebalancing your portfolio. The key question is how much to lower your commitment to stocks. Obviously, the level of your conviction plays a big role in this decision. Beyond that, let your age and the time until you'll need the money be your guides. James Stack, the bearish editor of InvestTech Market Analyst newsletter, says a young investor who has all his or her retirement savings in stocks could cut that position by 20% to 25%. Investors with five to ten years or less to retirement should reduce their stock positions by at least 50%, says Stack.

SHIFT FROM AGGRESSIVE STOCK FUNDS TO LESS VOLATILE FUNDS. Essentially, this involves dumping funds that own faster-growing stocks with high price-earnings ratios and the like, and replacing them with funds whose managers are more value- and yield-oriented. Because of the nature of this market, you'll probably have to overcome the psychological hurdle of dumping better-performing funds and moving into recent laggards. A fidgety investor might sell, for example, Harbor Capital Appreciation and Berger New Generation and replace them with T. Rowe Price Equity Income or Yacktman fund. The volatility rankings and down-market performance numbers in our August issue can help you identify tortoises with which to replace your hares.

INVEST IN A FUND DESIGNED FOR BEAR MARKETS. Two funds that are almost certain to rise in a falling market, says Stack, are Rydex Ursa and Prudent Bear. Ursa is designed to move in the opposite direction of the S&P 500. A majority of Prudent Bear's assets are in stocks sold short. Understandably, the records of both funds are awful.

USE HEDGING STRATEGIES IN YOUR BROKERAGE ACCOUNT. You can, for example, buy index put options as insurance policies. Gerald Kuschuk, head of options strategy at Prudential Securities, gives this example involving an S&P 500 index put expiring in 11 months: As of mid July, with the S&P 500 at 1184, a single "June 1175" contract would cost about $6,800--in effect, the insurance premium. If by the third week of June 1999 the S&P closed at 1175 or higher, the option would expire worthless. If, however, the market dropped 30%, you'd make a profit of roughly $27,000 on your option.

Pessimists can also sell short Standard & Poor's depositary receipts (SPDRs, or "spiders"), American Stock Exchange-traded vehicles that mimic the S&P, and so-called diamonds, which follow the Dow Jones industrials. The big plus of spiders and diamonds, says Kuschuk, is that you don't have to pay premiums to buy them. On the other hand, your maximum risk with index puts is the cost of the option. If you sell short a spider or a diamond, losses can pile up if the market continues to rise. Shorting involves selling borrowed securities in hopes of buying them back at a lower price.

Of course, all of this raises the issue of when you would want to get back into stocks or close your hedge position. And that is why timing the market is so much more difficult than simply holding good-quality stocks for the long haul.