The Best Way to Preserve Capital in a Bear Market

It’s a natural concern that every successful investor must live with. The concern is whether or not a bear market is near. Or, after a market selloff the investor must decide if a bear market is underway. Some financial advisers like to tell clients not to worry, markets always come back in the long run.

But, the truth is that bear markets destroy capital and change lives, sometimes. They should be a concern for every investor, especially if an investor has plans to retire one day or use their savings to send their children to college.

In other words, if they will need money at a certain time, bear markets should be a concern for an investor.

One way to deal with this concern is to follow the advice the financier J. P. Morgan supposedly gave to a dinner companion one evening. A woman told him she was pleased to be a shareholder in his bank but was so worried about a bear market that she was having trouble sleeping.

Morgan, according to legend, told her to sell enough shares so she could sleep at night. There is no way to know if this is true, but it is one approach to concerns of a bear market. However, this approach risks missing out on gains associated with a bull market.

A Better Approach

Rather than reducing your holdings of stocks when stocks are going up, you could use the market action to determine when to reduce exposure to the stock market. This is commonly known as a stop loss strategy, but it needs to be accompanied by rules on when to get back in.

One approach is to sell after a market declines by a predetermined percentage. The rules need to be predetermined in order to prevent emotional reactions to the market action. Emotional reactions, like bear markets, can destroy wealth.

One example of this approach is the Four Percent Model. Martin Zweig described this system in “Winning on Wall Street,” a book he wrote in 1986.

The Four Percent Model Indicator uses the weekly close of the Value Line Index and buys the market when the index rises at least 4% from its most recent low. This index was the first to offer futures contracts and was popular among traders at the time. Now, the S&P 500 Index could be used.

A sell signal is generated when the index falls at least 4% below a recent high. The idea behind this indicator is to always catch the major trends and avoid buying or selling on minor market moves.

In an update to his book, Zweig showed that from 1966 through 1993, the 4% long/short strategy delivered a 12.6% annualized gain, compared to a 2.7% gain for the index. Since that time, the model has matched the overall market performance, but reduced the risk of bear markets.

In other words, this strategy delivers the gains of bull markets with less risk than the overall stock market. The strategy is currently bullish after prices rose more than 4% above their recent lows.

SPY

Notice that there will be a significant number of short term trades but the rules will get an investor fully invested for all major trends.

A 10% rule will result in fewer trades and is still on the sidelines as the S&P 500 has not closed more than 10% above its closing low after the recent selloff.

SPY

An Adaptive Approach

Percent rules fail to adapt to the market which can leave an investor exposed at times. An adaptable approach uses the average true range indicator (ATR) to develop a stop strategy.

The ATR is customized to the personality of each stock. The true range is the distance between the high and low accounting for any gaps that occur in trading. A 14-day average of the true range is an indicator of a stock’s normal movement.

Multiplying the ATR by 3 finds the size of a price move that should only be reached in extraordinary circumstances. Subtract 3 ATRs from the closing price to find a stop level that accounts for the stock’s personality.

This will place stops far from the current price on volatile stocks and near the market price on stocks that hardly move at all like many utility stocks.

The 3 ATR stop can also be trailed higher as a trade moves in your favor. If the stock gains 10% after you buy it, you could reset the stop to account for the recent price action. Stops could be reset weekly or monthly but should always be updated to account for the most recent price action.

In the chart below, the 3 ATR stop is trailed upward, using the most recent market action to show the current stop level. Notice that there were only five sell signals in the past seven years, allowing traders to benefit from the generally rising trend.

IWM

If an ATR stop is used, it could be customized to accommodate risk preferences. While a 3 ATR stop is shown in the chart, a 2 or 5 ATR stop could be used by more conservative and more aggressive investors, respectively.

It will be important to have a rule for getting back into stocks if the ATR stop is used. For this strategy, a percent move could be useful. For example, an investor could exit on a 3 ATR stop and buy back into the stock market after a 4% or 8% rally. This would be a complete trading strategy.

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