Bringing Bear Market Strategies Out of Hibernation - TheStreet

Bringing Bear Market Strategies Out of Hibernation

Rubino says it is possible to profit from pessimism about the market. Have your say on our message board.
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The scary thing about this market is that you can make a plausible bear case without even mentioning Y2K. Put simply, stocks are as expensive as they've ever been and the economy is running out of slack. Labor is so tight that companies are having to pay up to keep good people. Health care and energy costs are rising again, and interest rates are up across the yield curve. The inevitable result: higher costs of borrowing and doing business, lower corporate profits and sinking stock prices.

Bear Market Strategy:

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In this scenario, the uptick earlier this week was a gift, the market's way of allowing you one last chance to get out in front of what's coming. Today's turmoil may be more typical of what's coming. So this week's column appears a day earlier than usual with some investing ideas for a bear market:

Load up on long-term Treasuries.

Rising interest rates will eventually slow the economy, causing rates to fall and bond prices to recover. When that happens, long-term Treasury bonds will score big gains.

Short the highfliers.

Shorting is selling a stock you don't own, riding it down and buying it back for less. As for what to short, the market has made that easy by dividing itself into a huge mass of losers (the average stock is down 20% from its 12-month high), and a handful of still very pricey winners.

General Electric

(GE) - Get Report

, for instance, is growing its earnings by only about 12% a year, while trading at a price-to-earnings ratio of 38.

Microsoft

(MSFT) - Get Report

and

Cisco

(CSCO) - Get Report

are trading at 60 and 109 times trailing 12-month earnings, respectively. These are spectacular companies, but in a general market decline, they've got a long way to fall. Other obvious short candidates include the Internets, some of which are at levels that just about guarantee a debacle if the overall market heads south.

In general, though, shorting individual stocks isn't the best way to bet against the market. Great companies can defy gravity for years, and since you eventually have to buy back the stock, your downside is theoretically unlimited. The next three strategies are better:

Short some SPDRs.

These are basically closed-end index funds that trade like stocks. SPDRs, or Standard & Poor's Depositary Receipts

(SPY) - Get Report

, match the

S&P 500

index. Similar securities include

DIAMONDS

(DIA) - Get Report

, which track the

Dow Jones Industrial Average

, and the

Nasdaq 100

tracking stock

(QQQ) - Get Report

, which is self-explanatory. They also come in sector flavors such as

technology

(XLK) - Get Report

and

cyclicals/transportation

(XLY) - Get Report

. Just short them like regular stocks, and you're covered. But again, remember that with all forms of shorting, your risk is theoretically unlimited.

Buy LEAPS puts.

LEAPS, or Long-Term Equity AnticiPation Securities, are options with a twist. Like traditional options, LEAPS give you the right to buy (i.e., calls) or sell (puts) a stock or market index at a given price within a given period of time. But instead of expiring in a few months, LEAPS can run for up to three years, letting you be wrong on the timing but still make money from a correction sometime in 2000. So they're a safer, cheaper alternative to shorting a bunch of overvalued stocks. More on both SPDRS and LEAPS can be found at

www.nasdaq.com .

Buy bear funds.

A handful of funds are designed to go up if the market falls. But their methods vary, so look before you buy. The

(BEARX) - Get Report

Prudent Bear fund, for instance, is a mirror image of the typical actively managed fund. It's run by short-guru David Tice, who picks overvalued stocks and shorts them. Tice's newsletter,

Behind the Numbers

, made a prescient call on

Tyco

(TYC)

recently.

ProFunds

runs a family of index funds that includes four bears. Instead of picking individual stocks, ProFunds uses futures and related options to target a given beta, or volatility relative to a market index.

(BRPIX) - Get Report

ProFunds Bear, for instance, is designed to go up exactly as much as the S&P 500 goes down, for a beta of minus 1. The

(URPIX) - Get Report

ProFunds UltraBear has a beta of minus 2, meaning that it aims to rise twice as much as the market drops. The family also includes funds linked to the Nasdaq 100 and a European large-cap index. "With our two-beta funds, you get the effect of leverage without having to pay for margin," says Louis Mayberg, ProFunds' president.

These bear funds have a lot going for them. They're no-load, so you get in without a transaction cost. They spread your capital among lots of different stocks and/or options, so one moonshot isn't catastrophic. They can be bought in nonoption, nonmargin accounts, just like any other mutual fund. And unlike traditional shorting, they limit your liability to the amount you invest. But remember, they're still an emphatic bet on the direction of the market. If you're wrong, and stocks keep going up, bear funds will get killed. In 1998, for instance, Prudent Bear and ProFunds UltraBear were down 34% and 38%, respectively.

For a comprehensive look at the bear market case, check out Bill Fleckenstein's "Spinning Financial Illusions: The Story of Bubblenomics," on

www.siliconinvestor.com.

John Rubino, a former equity and bond analyst, writes a column on mutual funds for POV and is a frequent contributor to Individual Investor, Your Money and Consumers Digest. His first book, Main Street, Not Wall Street, was published by William Morrow in 1998. At time of publication, he owned shares of the Prudent Bear fund. While Rubino cannot provide investment advice or recommendations, he invites your feedback at

rubinoja@yahoo.com.