The 5 Mistakes To Avoid In A Bear Market

ETFguide.com
The 5 Mistakes To Avoid In A Bear Market
Friday October 17, 11:15 am ET
By Simon Maierhofer

As the captain of a large vessel navigates through high seas, he spots a light on a collision course. 'Change your course 10 degrees East' he signals. 'You change your course 10 degrees West' he gets in return. His reply: 'I am a Navy officer, so you change your course' is met by 'I am a seaman of second degree, you change your course'.

The captain is furious and sends his final warning, 'I am a battleship and won't change my course'. Is there any reply that would change the captain's mind? The final signal received is: 'I am a light house, your call'.

Nobody likes change

Change, we all dread it and often push it off to the very last moment, but ask yourself, is my portfolio heading for the cliffs? Individual storms and currents have united and formed a perfect storm. Don't allow your portfolio to shipwreck.

Red across the board

If you are still in denial or bent on riding this one out, consider the following: The Dow Jones (AMEX: DIA - News) and S&P 500 (AMEX: SPY - News) have shed over 40% since last year's high. Gold, albeit more stable, is down 20% from its all time high. The SPDR Gold Trust (NYSEarca: GLD - News) and iShares COMEX Gold Trust (AMEX: IAU - News) are flat for the year. Silver, represented by the iShares Silver Trust (AMEX: SLV - News) has lost nearly 50%.

The extent of the bear

What we've witnessed over the past decade was not just a simple bull market, it was more, it was a mania. This mania first drove up tech stocks just to drop them like a hot potato, next in line was real estate, followed by commodities. Take a look at the Nasdaq (Nasdaq: QQQQ - News). It tumbled as much as 80%. Even as the Dow Jones recorded a new all time high (Oct. 2007) the Nasdaq was still off 56%.

Light crude oil was supposed to be trading at $200/barrel (according to analyst projections) but broke below $80/barrel. The United States Oil Fund (AMEX: USO - News) is down 50%. The PowerShares DB Agriculture ETF (AMEX: DBA - News), a composite of wheat, corn, sugar and soybeans melted by 40% in less than four months. Real estate: The Dow Jones Wilshire REIT ETF (AMEX: RWR - News) and Vanguard REIT ETF (AMEX: VNQ - News) lost 20% in less than 40 days.

A window to the future

There is more hurt in store for the U.S. equity markets. If you are still thinking of riding this one out, consider Japan. Japan's Nikkei 225 is our window into the future. From its 1990 high of 40,000 it fell as low as 7,800, an 80% drop. A similar correction in the U.S. would translate into Dow 2,500.

Japan's economic correction occurred amidst a raging, global bull market and was thus long and drawn out (1990 - today). U.S. equities will tumble faster in a global bear market. The iShares MSCI Japan (NYSEarca: EWJ - News) seems in line of a decent counter rally before the down trend continues.

As discussed in ETFguide's ETF Profit Strategy Newsletter (a subscription based publication), any bailout or globally orchestrated interest rate cuts won't fix this ship just as no ordinary water pump could have kept the Titanic afloat.

5 mistakes to avoid in a bear market

When the time is right, you need to be ready to ACT NOT REACT. Here are a few tips that will help you make the right decisions:

1) You don't drive looking in the rear view mirror, why invest that way?

Don't become a performance chaser. The notion of a fund or ETF continuing to go up just because it's been up in the past is flawed. When playing roulette, you don't bet on black just because black worked in the past. The chance is 50/50 regardless of the past.

Morningstar is trying to force a square peg into a round hole by applying backward looking mutual funds star ratings to ETFs. The iShares FTSE/Xinhua China ETF (NYSEarca: FXI - News) received the much coveted five-star rating early in 2008. FXI has tumbled 50% since.

ETFguide sold FXI in its Ready To Go Model Portfolios at its all time high of $219 (before the split). Morningstar crowned two PowerShares ETFs (PWV and PWJ) with a five-star rating in August. PWV and PWJ lost 25% in the past 30 days. Morningstar's ratings don't work for mutual funds and will never work for ETFs.

2) Don't get fooled by sucker rallies

Japan experienced a handful of 30%+ counter trend rallies over the years (the correlation between Japan and the U.S. is further discussed in our ETF Profit Strategy Newsletter) all of which resulted in eventual lower lows. Such 'dead cat bounces' fool investors into thinking everything is all right before the market delivers the next knock-out punch. For a good reason, counter rallies have also been termed sucker rallies.

Don't be a sucker, use sucker rallies to sell unwanted positions and add short position. UltraShort S&P 500 ProShares (AMEX: SDS - News) or inverse sector ETFs like the UltraShort Financial ProShares (AMEX: SKF - News) can be picked up as a hedge position at discount prices during counter rallies.

3) Know your numbers

The average investor lost 40% over the past year. Like most, you likely think that 40% can be recovered with a buy and hold strategy. A strong counter trend rally (if timed to perfection) may deliver a 40% move. However, if you've lost 40% you need to pocket a 66% gain just to get even. If you've lost 50%, you need to double your remaining money to get even. Know your numbers and fold when it's impossible to get even.

4) Don't fight the tape

A look at the Dow Jones and S&P 500 charts clearly shows that investors don't want to own stocks right now. This is confirmed by the broad Vanguard Total Stock Market ETF (NYSEarca: VTI - News). Don't fight a confirmed down trend, it would be like going up the down escalator.

5) Use common sense

Unfortunately, common sense is not so common. You can't force a winning portfolio. All boats sink with the tide. If you don't want your boat to sink, pull it on shore and wait for the tide to come back. You can park your money in short term Treasuries, such as the iShares Lehman 1-3 Year Treasury Bond ETF (NYSEarca: SHY - News) or the iShares Lehman Short Term Treasury Bond ETF (NYSEarca: SHV - News).