Possibility of a Bear Market Doesn’t Mean Investors Have to Hibernate

Worried about the market’s wild gyrations? Want to protect your stock profits?

You’re not alone. With the bull market showing signs of gray hair in its sixth year, some experts say the risks of a decline may outweigh the opportunities for further gains. So caution may now be rewarded more than greed.

“The most important thing is not how much money you make in a bull market but how much you avoid losing in a bear market,” said Charles Allmon, editor of Growth Stock Outlook, a newsletter published in Chevy Chase, Md.

Stock Strategies

No one knows for sure whether the bear market has started. But here are some tips on how you can protect yourself in case it has, while allowing yourself room to make more money if the bull is still alive:

- Enter stop-loss orders. Tell your broker to have your stock sold if it falls to a certain price below its current level. Such stop-loss orders are allowed for shares on the New York and American stock exchanges but not allowed for over-the-counter issues.

There is one disadvantage, however: Your stock could hit the stop-loss price only to rebound and shoot back up again. So make sure that the stop-loss price is sufficiently below the current price to allow for short-term swings. Some experts suggest setting your stop-loss at 10% below the current price for relatively stable stocks and at 15% or 20% below for more volatile issues. And consider adjusting your stop-loss level upward if its price moves upward.

- Buy put options. This gives you the right to sell your stock at a particular price within a particular period, locking in your profit. For example, if you own 100 shares of a stock selling at $100, you could buy a put on those shares that will give you the right to sell them at $100 anytime during the next three months.

Thus, if the price closes below $100 at or before the expiration date, you could exercise the option and sell the shares at $100. Your only loss is the commissions and the cost of the premium you paid for the option, which in this example could run between $1 and $10 a share, depending on the stock’s volatility and dividend.

- Sell gradually. Sell a set portion of your portfolio each month, being careful to minimize commission costs. Or sell a portion each time the stock moves up or down by 5% or 10%. Such installment selling, a reverse form of dollar-cost averaging, allows you to take advantage of any possible upswings in the stock’s price. Usually in a bear market, stocks don’t go straight down; instead, prices tend to zigzag.

Of course, if you think a collapse is imminent and you don’t mind paying capital gains taxes on all of your profit, you can sell everything at once. In a real bear market, you may not want to be in stocks at all. As a general rule, 95% of all stocks go down in a bear market.

- Sell stocks that are overvalued or that could do poorly in a downturn. Elaine M. Garzarelli, director of sector analysis for Shearson Lehman Bros., suggests getting out of stocks in cyclical industries such as paper, aluminum, computers and drugs.

- Sell short. This is one of the best ways to profit from declining stock prices, yet it is often under-used. “It’s a great strategy, but a lot of people don’t do it because (they think) it’s un-American,” said analyst Garzarelli, who is shorting a number of stocks in her own portfolio.

In selling short, you in effect borrow stock at the current price and promise to buy it at some later date, hoping that the price will be lower so you will make a profit. However, if the price is higher, you lose money.

How can you protect yourself from large losses in short selling? One way is to tell your broker to automatically “cover” your short sale if the stock goes up a certain amount, say 5%. That means that you will buy the stock if the price goes 5% higher, in effect limiting your loss to 5% plus commissions even if the stock later rises more than that.

- Invest in ignored and undervalued stocks. The theory is that since these issues haven’t risen as much as others in the bull market, they won’t decline as much in a bear market.

Monte Gordon, director of research for Dreyfus Corp., a mutual fund company based in New York, says utility, insurance, food, tobacco and bank stocks are undervalued and may do better in a bear market.

Geraldine Weiss, editor and publisher of Investment Quality Trends, a La Jolla newsletter, suggests eventually selling about half of your portfolio and using the funds to buy undervalued stocks in such industries as utilities, banking and hospital supplies.

Unless you are aggressive and bullish about the market, avoid the blue-chip issues of the Dow Jones average of 30 industrial stocks. They have risen the most in the current bull market but stand to fall the most once the bear market starts, says Robert R. Prechter, editor of the Elliott Wave Theorist, a Gainesville, Ga., newsletter.

- Buy high-dividend paying stocks. Some utility stocks are paying dividends at the rate of 8.9% of the stock price, Shearson’s Garzarelli said. And utilities won’t do as poorly in bear markets, she said. “If the market goes down 15%, they’ll go down only 5%,” she said.

- Invest in companies with low debt. They generally are better equipped to ride out a recession or rising interest rates, newsletter editor Allmon says.

Mutual Fund Strategies

- Make sure your mutual fund company allows you to switch money from your stock fund into a money-market fund. Because of their relative safety and stability, money-market funds are excellent places to park your funds while the stock market is plummeting.

Beware, however, that switching out of a fund is treated as if you had sold out of it. Any profit is fully taxable, said Lewis Wallensky, a Los Angeles financial planner. So be careful if you want to avoid a big capital-gains tax hit.

- Invest in funds with proven strong track records in bear markets. Allmon suggests investing in funds that are willing to carry high cash positions to cushion themselves against losses. One such fund, he said, is Mutual Shares.

John Markese, director of research for the American Assn. of Individual Investors and editor of the group’s guide to no-load mutual funds, says funds that stress dividend income as well as capital appreciation will do relatively well in bear markets. Two such funds, he suggests, are Evergreen Total Return and Ivy Growth. Markese also recommends funds specializing in undervalued stocks, such as Quest for Value.

Alternatively, avoid funds that take larger risks by being less diversified or by borrowing money to invest in stock and create leverage. While they do well in strong bull markets, they get killed in bear markets. One such fund that has performed poorly of late is 44 Wall Street, which holds only a small number of issues. Experts also advise conservative investors to avoid sector funds that invest in just one industry, such as real estate or entertainment.

- Be wary of newer funds with no track records in bear markets. Many funds created in the go-go stock days of the late 1960s slumped badly in the bear markets that followed. The same could happen to the hundreds of new funds created in the current bull market.

“If the portfolio manager is under 30 years old, you better sell tomorrow,” Allmon suggested. “The last thing you want is some fund run by some kid” with no experience managing money in a bear market.

Alternative Investments

- Consider shifting money into bonds, certificates of deposit or other fixed-income investments. Yields on bonds have risen dramatically in recent months, making them increasingly attractive relative to stocks, says Richard H. Fontaine, president of the T. Rowe Price Capital Appreciation Fund.

But be careful with long-term bonds and long-term bond mutual funds. While they yield more, their principal value, or price, fluctuates more than short-term issues for a given change in interest rates. (Bond prices fall when interest rates rise, and vice versa.) Conservative investors should stick to shorter maturities, Fontaine said.

One example of a good buy is four-year Treasury notes, which sold at auction earlier this week at a yield of 9.24%, up from 7.89% at the last comparable auction June 24. Because of their relatively shorter maturity, such issues have far less capital risk than 30-year Treasury bonds, which yield about 9.8%.