How to trade a bear market in stocks

Our Medium-Long Term Model states that the current bull market in U.S. stocks still has at least 2-3 years left.
Many readers have asked me:

You buy and hold UPRO during rallies within bull markets. You switch to 100% cash during significant corrections within bull markets. So what do you do during bear markets?

Here’s my answer.

What the Medium-Long Term Model can and cannot do

The model can predict when a bear market will begin and when a bear market will end.
HOWEVER, it cannot predict rallies or declines within a bear market. In other words, it cannot predict the S&P 500’s medium term direction within a bear market the way it can predict the S&P’s medium term direction within a bull market.

  1. Every bear market is inherently different. There are very few patterns that the medium term waves of bear markets follow.
  2. The medium term direction during bear markets is HEAVILY influenced by news. The medium term direction during bear markets is driven by neither fundamentals nor technicals nor patterns.

Notice how the past 4 bear markets have gone down in significantly different ways.
Here’s the 2007-2009 bear market. Notice how the market CRASHED in 2008.

Here’s the 2000-2002 bear market. Notice how the S&P went down in very large and distinctive waves.

Here’s the 1973-1974 bear market. Notice how the market grinded down.

Here’s the 1968-1970 bear market.

Hence, the Medium-Long Term Model’s average return per annum of 45% since 1950 is based on HOLDING CASH during bear markets.
Here are some other trading strategies you might want to use during bear markets.

Bear market trading strategies

All of these strategies have one thing in common.

Hold a lot of cash and do not go all-in. The big money is made by riding bull markets. Focus on survival during bear markets.

The worst thing to do: short the stock market when it’s  going up
Our Medium-Long Term Model will sometimes call the bull market top a few months early. This is completely normal because nobody can catch the top perfectly and consistently.
For the love of God, do not short the stock market as it is going up. The stock market has a long term bullish bias, which means that the S&P 500 can go up for MONTHS even as the economy’s wheels have started falling off. There is too much dumb money.
Being early and being long is ok. You just need to buy and hold. Being early and being short is deadly. Your losses on the short side are theoretically infinity, and you may be margin-called at the market’s exact top (i.e. right before the market goes down).
Short the stock market once the bear market has definitely begun
Our Medium-Long Term Model has not failed to predict a historical bear market. But in the case of such a failure, the model has a backup component.

This backup component tells us “once XYZ has happened, a bear market has ALREADY begun. The current decline is the first leg in a bear market. It is not a significant correction within a bull market.”

Shorting once the bear market is GUARANTEED is a much safer way to play the bear market. It is less profitable than trying to catch the exact top, but it is much safer. Focus on capital preservation.
Long-term put options (aka LEAPS)
These are put options with more than 9 months until expiration. When buying a long term put option, you’re essentially saying “I don’t know when the market will go down, but when it does go down, it will go down bigly” (to use The Donald’s favorite word).
The beauty to buying options is that you only have to commit a small part of your capital. It’s an assymetric trade. Your potential losses (the premium) are much smaller than your potential profits (because the S&P falls a lot during bear markets).
This trade sounds great on paper. However, there is one problem to it. Long term put options tend to have very expensive premiums. So unless you can find LEAPS with cheap premiums, this might not be the best way to trade a bear market.

3 comments add yours

  1. Thank you, Troy. I have been reading your post for a few weeks now. For a newbie like me, this is the best post yet.

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