With this Bear-Market Insurance, You Can Keep Riding the Bull

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During the last few weeks, the U.S. stock market has recovered from its mid-February swoon and clawed its way to a new high for the year - returning share prices to levels not seen since late 2008.

At this point, based on consideration of its change in value since the money supply inflation began in early 1995, stocks appear to be substantially overvalued, perhaps by as much as 40% to 50%.

However, if our experiences of the late 1990s taught us anything, it's that the stock market can remain overvalued for years - meaning investors who opt out of the market completely risk getting left behind.

Still, given the soaring run-up we've seen since the stock market's March 9, 2009 nadir, I thought this would be an excellent time to review the ways nervous investors can protect themselves - even as they remain invested. That's just good, sound risk management.

And there is a way to achieve both goals - with a type of bear-market "insurance' that's fairly easy to use.

Why Cash Isn't (Currently) King

For investors, the most dangerous tendency is to get carried away by the state of the market at any given time. That's especially true in a period like the present, when the market has dropped by more than 50% and then rebounded. If you'd held a balanced portfolio since 2007, you would have not done too badly: You would only be down about 15% from the absolute peak.

However, many of our portfolios were unbalanced. In 2007, for example, many people overloaded on financial stocks, which appeared cheap compared to their earnings potential. That would have been a mistake if you'd held them until now. However, the act of rebalancing your holdings as the stock market fluctuated could have led you into even more serious mistakes - such as selling out of commodities and energy stocks at the bottom of the market in late 2008, just before those sectors began a magnificent rebound.

To better see what I mean, take a look at Teck Resources Ltd. (NYSE: TCK), the Vancouver-based natural-resources player whose shares zoomed from less than $4 a share to more than $40 during this period. Missing that gain would be bad enough. But imagine how you'd feel if you'd bought Teck at $40, or even $50, in late 2007 or early 2008 - and then sold at the bottom.

The overall performance of Teck's shares during those two years is acceptable - just a modest loss in line with the market - but the wrong timing would have wiped out more than 90% of your investment.

To avoid losses, the simplest strategy is to go into cash when you think the market is too high. But from a psychological standpoint, that's damned near impossible to carry out.

Nor is that the only issue with strictly cash investments.

Right now, with a cash investment, investors are looking at a negative real return - thanks to short-term interest rates that are lower than the rate of inflation. So you don't want to hold too much cash.

If you do go into cash - only to have stock prices track higher - it will feel to you as if everybody else is making money, while you aren't. The emotional tendency is to reverse your decision, and deploy your cash. And the odds are strong that you'll do so near - or right at - the very top of the market.

Conversely, at the bottom of the market, even if you have cash available, it seems like madness to invest it in stocks, especially since you probably view them as "those lousy investments" on which you have lost so much.

Inverse Funds Lack the Reach

It's possible to hedge against bear markets by buying so-called "inverse funds," such as the Rydex Inverse S&P 500 Index Fund (RYURX) or the Prudent Bear Fund (BEARX). These give you excellent protection against a downturn - at least as far as the amount that you have invested in them: By and large, for every 1% loss in the market, you will make a 1% gain on your holdings in these funds.

As I said, though, your protection is limited to the amount you invest in these funds: To get full protection against a downturn, you have to put half your entire portfolio in them, which reduces the amount of money on which your investment skill can make gains. Since the two halves will balance out, you are liable to find yourself investing huge amounts of money, and achieving a rather-wobbly zero return. As was the case with our cash example, you will be tempted to sell out of these bear-market funds the top of markets and pile into them at the bottom - not a winning strategy, needless to say! 

The ideal protection, therefore, is something that requires investing only a modest portion of your capital - say 5% a year - and that pays off on a leveraged basis. That will result in a true investing bonanza when the market really falls out of bed, thus giving you new cash to invest at the bottom of the market.

Essentially, you are looking to buy an insurance policy on your portfolio. Here's how to do it.

Insurance That Ensures Investment Returns

The type of "insurance" I'm referring to works like this: If the market rises or stays flat, you will pay 5% of your portfolio a year to insure it. That means, for example, that if the market advances 20%, your net return will be 15%.

However, if the stock market drops 50%, you will make 20% or 30% of your portfolio's value in cash, thus protecting yourself against much of the loss while also providing yourself two very important benefits:

  • You gain cash to invest at the market bottom.
  • And you gain confidence in your investment skills - no small thing at a time when virtually everyone else is scared, shell-shocked, or too paralyzed with fear to make a move.
Fortunately, an investment with precisely these characteristics exists, in the form of long-dated Standard & Poor's 500 Index "put" options, traded on the Chicago Board Options Exchange. These "puts" theoretically give you the right to sell a basket of stocks replicating the S&P 500 at a fixed price on, or before, some fixed date in the future. They are highly liquid, and they have "strike prices" (the price at which the option can be exercised) that are:

  • Close to the S&P's current trading price.
  • Far above that market price (referred to as being "deep in the money" for put options).
  • And far below the stock's current market price (known as being "out of the money" for put options). 
What's more, put options exist for maturities as far out as December, two years from now. In other words, during 2009, the longest-available maturity was December 2011. Now, it's December 2012.

By buying "out-of-the-money" put options, with exercise prices well below the current price of the index, you don't pay too much upfront. But if the market descends to a point that's near, or even below, your strike price, you can make a big profit of several times your investment. So if each year you invest 5% of your money in "out-of-the-money" puts, with a strike price 400 or 500 points below the current price, and a maturity of more than two years, you will protect yourself against a big drop in the stock market. The previous-year's options can either be held, in the hope that this is the year of the big drop, or sold to finance your new purchase, as preferred.

There's an additional small wrinkle. Options prices depend on the strike price, the current market price, interest rates and the "volatility" of the market - how much it bounces up and down. But we really don't know how much the market will bounce up and down in the future, so options trade according to traders' expectations of volatility. Those expectations are charted and watched via the Volatility Index, or VIX.

If the stock market is good, as it is now, that expectation (the VIX) is low - it's currently around 17.

If the market falls out of bed, however, assumed volatility zooms skyward: The VIX got to 85 in 2008. So put options bought in good markets and sold in panics have an extra-juicy bit of profit potential from volatility rising.

In March 2009, the S&P 500 bottomed at 676. So today you might look for a December 2012 option with a strike price of 600 to 700. At present, the 600 puts trade at a mid-price of $19.90; the 700 puts trade at about $31.90.

The options are traded in units of 100 contracts, so if you bought one 600 put and one 700 put, it would cost you $5,180, just about the right amount of "insurance" for a $100,000 portfolio. That purchase would give you the right to sell 100 contracts at 700 and another 100 at 600; in other words, you would have bought put options for $130,000 of stock.

If the S&P 500 drops to 650 within the next year or so, and volatility rises, those options would be worth perhaps $35,000 between them. Thus, if you sold them, you would recover most of your market losses and would have $35,000 in cash to invest at the market bottom.

For me, this is the intelligent way to remain invested, while protecting yourself against the potential for a major market reversal.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock-market rebound that started in the middle portion of March 2009, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please click here.]



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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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