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Sound Investing in the Coming Bear Marke

We are in a bear market. The stock market has essentially moved sideways or down since last July, and while it is not quite 20% below last year’s peaks, just wait. Don’t get trapped in a state of denial. The evidence is glaring-the subprime mortgage and CDO write down debacle, a host of toxic credit and debt derivatives, the banking and financial credit freeze, bursting real estate bubble, pathetically eroding value of the dollar, horrendous federal budget deficits and spending, panicky ETFs to Reduce Downside Volatility federal reserve interest rate cuts, the demise of Bear Stearns, ineffectual federal refund stimulus, bond insurers at bankruptcy’s door, an economic recession, consumer spending retrenchment, flat or eroding employment levels, an inflation CPI of +4.3% (5%-8% if including food and energy). Can you say, stagflation? Even sharply reduced interest rates haven’t helped.

The economy runs in cycles. The last real downturn was in the early ’90s. Government leaders, bankers, the media, investors are nervous. A crisis of confidence is unfolding. The excesses of the late ’90s Internet bubble, the recent real estate bubble, and the spread of junk-mortgages foisted off as AAA-rated debt, all need to be washed out of the system before there is a return to normalcy.

Wall Street Won’t Admit to Bear Market

In my book, Full of Bull, I stress the point to never take Wall Street literally. I spend a few chapters decoding the array of misleading and confusing Street directives so investors will not be led astray. One of the most adverse Street influences on sound investing is its eternally favorable stock market bias. You can’t rely on the Street to warn you of a negative outlook or high risk. It terms a falling market as “volatile,” never wanting to utter pessimistic adjectives. A market drop is a “correction,” but a recovery is never called a “mistake.” So far the stock market falloff has lasted 4-6 months, yet the brokerage research investment rating distribution is 49% Buy, 46% Neutral, and just 5% Sell recommendations. Brokerage firms generate commissions by selling to investors new and used stocks and bonds. It’s a conflict of interest. Why would they ever be bearish on the products they want to sell to clients? So don’t expect objective, cautious advice-even in a bear market-from Wall Street. The Street won’t even admit to the recession. The Administration, even the Federal Reserve, is the same, always perceiving the outlook positively. Barron’s summarizes this attitude: “Fundamentally everything’s fine, but, not to worry, it’ll soon get better.”

If you listen to Wall Street, the Administration, Federal Reserve, or the cheerleading media such as CNBC, they all claim we’ll be past these problems and rebounding again by the second half of this year. They’re all pie-eyed optimists. It’s what you’d expect. But I’m telling you, just wait a couple months, the Pollyannaish forecasts will start slipping, pushing the rebound to late this year or even into early ’09. The first bad news is never the last. It’s not a matter of a whether there will be a soft or hard landing for the economy, but rather how hard will be the landing. This is the first consumer spending-related recession since ’91-’92. It may last as long as housing prices are depressed. Election year uncertainties and the bitter medicine forthcoming next year with a new administration are not a pretty picture. Financial institutions will be chary to lend for a long time, with more bad news such as delinquent credit card debt yet to surface. Global corporate earnings are declining. The stock market is still valued at a PE multiple above the long-term trend line, and that’s not reflecting more earnings estimate reductions ahead. It seems to me that the bear market will endure well through this year and next year. Your investing should encompass this wary perspective.

Protect Your Capital

Protection of capital is paramount, especially now during a deteriorating market. Investment capital is too difficult to replace. A 35% drop in value requires a 54% recovery to get back to even. The point is don’t lose; avoid incurring whopping losses. You must assess the downside risk of every investment in your portfolio. Assume essentially the worst. Don’t look to Wall Street to disclose the lowest price potential of stocks under research coverage. Isn’t it curious how research reports indicate the upside price target, but rarely the worst price risk? Derivatives such as stock options, puts and calls, are probably the highest risk investment, given the leverage. Individual common stocks are next. Stock index funds, exchange traded funds, are slightly less dangerous. Diversified mutual funds are lower on the peril scale. After that it’s bonds, followed by cash on the risk spectrum. Take a close look at your investment mix. In the coming bear market, be sure your positions are weighted toward the safe end of the hierarchy.

There are reasons to continue holding stocks in a portfolio, even in a market fall-off. If you’re like me, you own stocks with healthy gains that you want to retain for a number of years in the future. Selling these would incur capital gains taxes, and the tendency is to never get around to repurchasing them later. And if you follow my advice in Full of Bull, they are paying respectable dividends, which represent an important income stream in your financial picture. (Historically, from 1926-2006, some 41% of the total stock market return was derived from dividends, 59% from stock price appreciation-thus, my emphasis on dividend paying stocks.) If these dividend payers were purchased at lower prices, your yield is likely to be maybe around 10% or even higher. You don’t want to give that up. The question is the portion that stocks overall should represent in your portfolio during a bad market. I believe investors should reduce their weighting in stocks by 30%-50%, even if that means giving up some dividend income for a while. It’s all about preserving your capital.

Low-Risk Stock Strategy in a Slumping Market

As the bear market plays out, the potential price decline is more limited in stocks with modest PE multiples and stout dividend yields. For sure, they are not immune to an eroding market. But their risk is far less than high valuation growth stocks. Corporate earnings are a key support factor in this scenario. PE’s don’t mean much if the “E” is not dependable. Earnings stability is a vital underpinning to help moderate stock price downside. The PE ratio can shrink, but not excessively if the starting point is already reasonable, say a PE of 10x to 15x. The stocks to own amidst a deepening recession are ones where profitability is not cyclical, at least where the earnings outlook is immune to current conditions, such as oil and gas pipelines and storage, and ocean shipping. Incidentally, this type of stock is a sound investment during bull markets too.

Dividend yield is the other important buttress. It is an indicator of financial stability, good cash flow, and quality. As I point out in Full of Bull, there is a direct, positive correlation between dividend payout ratios and earnings growth, according to studies such as one by Robert D. Arnott. This is a startling relationship. Over time, the higher the payout, the faster the earnings pace. A $20 stock that pays an $0.80 dividend, a 4% yield, is unlikely to plummet below $10 that is, an 8% yield, if the earnings and cash flow are stable. The worst case scenario is more likely around $12, a 6%-7% yield-the dividend, if safe, provides an effective safety net. And an investor should seriously consider buying more shares at that depressed level.

Consider Other Defensive Strategies

In the current troubled financial outlook, gold, in my view, is a solid investment. During a crisis or a highly uncertain economic period, gold represents a safe-haven. The weakening dollar, financial institution plight, and inflation all point to gold as a means to protect the value of your capital. Exchange traded funds (ETFs) are a particularly easy method by which to own gold as a commodity. They are a pure play, rigorously track the price of gold, are actively traded, and listed on major exchanges. A drawback to gold-related ETFs is that gains are taxed as collectibles, at a maximum of 28% rather that the 15% long-term capital gains tax on stock appreciation.

Shorting stocks is another defensive measure during a major stock market fall-off. But this is more speculative, so it should only represent a tiny portion of your investment portfolio. Betting that a stock will decline carries with it the possibility of infinite losses since stocks can rise forever but only decline to zero. Timing, volatility, even brokerage availability of shares to lend out are issues. Identify industry sectors that will be heavily impacted by the recession or other crosscurrents in the economy. Seek companies that are the most vulnerable. And select stocks with valuations that still have ample room to contract. The process is challenging since the stocks most susceptible to the dangers ahead are obvious and have already collapsed, such as in the home construction, banking and brokerage, and consumer retail sectors. You need to be on the early side and have reasonable insight. In the case of shorting, I would fervently advise cutting your losses if the shares move in the wrong direction and rise by 10%. It’s a tight leash because the risk is so pronounced. Still, shorting is a means to offset declines in your long-term, high quality, value-oriented, dividend-paying stock investments.

Accept and Be Prepared for Bear Market

The most challenging aspect of readying your investment portfolio for a major stock market falloff is recognizing the ominous conditions, the deteriorating stock market, and that there is worse yet to come. The investing element is more straightforward, determining the appropriate, expendable stock positions that can be sold to generate cash. An important goal is to establish a pile of cash, or a liquid equivalent such as a true money market fund, to relish while the rest of the market tanks. Bear markets are deceptive, behaving in a manner that disguises the downward drift. Each time there occurs a precipitous drop, it is followed by a modest recovery. It’s two steps down and one step up, just to keep you confused and to give false hope. Once bear markets are widely identified it’s too late, everything has plummeted. Bear markets move in phases, and in the end, everyone gets hurt. But this painful stage has not yet happened. Right now is about the last chance for you to alter your portfolio and tailor it for the coming bear market.

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