Ideas for a Bear Market

As I outlined last week, I’m not too confident in equities for 2007. If you're on the same side of the fence, it may be time to reduce your equity exposure. Here are some investments that should perform well in a bear market:


Bond Funds
Stick more of your money in bonds. If the futures trading activity is any indication, there is a much higher probability of a Fed cut this year than a rate hike. When interest rates are going down, the prices of bonds rise.

My recommendation would be First Trust’s Strategic High Income Fund (NYSE: FHI). FHI is a high-yield bond fund with an astounding 9.2% dividend yield! If rates do indeed fall, you will gain both appreciation and dividends. If it stays flat, you’ll still realize a 9.2% gain while the stock market struggles. And because it’s an ETF, you have several advantages over traditional mutual funds: you can buy & sell like a stock, fund expenses are much lower, dividends are paid monthly, there are no redemption fees for investing less than 1 year, and you are not dealing with a 3rd party.

Short Funds
If you are 100% convinced that the stock market will crash in 2007, check out ProShares family of Short Funds (some call them the “Un-American” funds). These ETFs are designed to move in opposition to the major indices such as the Dow, Nasdaq, S&P500 & MidCap400.

For example, if the Dow Index falls 10% in 2007, the Short Dow30 Fund (NYSE:DOG) will gain 10%. Even more confident of a down market? ProShares also offers “Ultra” Short funds that move 2x in the opposite direction. For example, if the Dow falls 10%, your UltraShort Dow30 Fund (NYSE:DXD) will gain 20%! As you may have guessed, these funds struggled during 2006’s bull market losing 13% and 26%, respectively.

Be aware that the UltraShort Funds are VERY risky and should not be markup a large percentage of your portfolio unless you are either Nostradamus or executing a short-term trade. For example, if the US invades Iran or there is another domestic terrorist attack, the UltraShort funds could protect your holdings while the predictable selloff occurs.

A more conservative play is the Prudent Bear Fund (BEARX) which invests in a variety of securities that perform well in down markets: short sales, futures, CDs, value stocks. I’ve held this mutual fund for roughly 6 months, and despite the huge run in the stock market, it’s held up pretty well. Plus it pays a nice dividend. This is by far the most widely-held bear fund & is actively managed, unlike most ETFs.

Energy and Defense
Energy and Defense-related stocks generally perform well in bear markets. Energy stocks have been struggling the last several months as the price of oil has fallen over 35% from its peak of $78.40 last summer. There were 3 key reasons for this fall:

· Unusually warm winter weather
· Absence of geopolitical risks
· Concern whether OPEC can control rising inventories

But oil appears to have reached a bottom as it was met with huge resistance at the key $50 level this week. Bullish sentiment from veteran investor T. Boone Pickens helped oil when he was quoted in The Wall Street Journal as predicting an average price of $70 a barrel in 2007. I would recommend the US Oil Fund ETF (NYSE:USO) that follows the price of crude without having to deal with futures contracts. Otherwise, the Oil Service Holders ETF (NYSE:OIH) is a more diversified basket of energy stocks that should perform well in a bear market & as oil recovers.

Also take a look at alternative energies. At Tuesday's State of the Union Address, President Bush is set to unveil his strategy to confront global climate change and work toward energy independence. PowerShares WilderHill Clean Energy Fund (AMEX:PBW) is an ETF that includes solar power, ethanol, wind & carbon energy stocks. With Bush finally admitting our "oil addiction" and the Democrats getting serious about global warming, these stocks should see increased exposure & possibly government funding.

Defense stocks have also been struggling as geopolitical conflict has been relatively quiet (with the exception of Iraq). Any conflicts with Iran, North Korea, Afghanistan, Venezuela or Syria (just to name a few) would aid defense-related spending. Also keep in mind President Bush is approaching his final year in office. Remember what his father did during the last few months of his Presidency?

Democrat-Related Stocks
One warning with Energy & Defense-related stocks: these normally do not perform as well when Democrats hold office. With the Democrats holding majorities in both the House & Senate, more focus could go to alternative energy, stem cell & biotech companies. But this may not happen until Bush leaves office and loses veto power. If a Democrat wins the Presidency next year, avoid health care, defense, pharmaceutical & oil companies.

Bearish in 2007

I’m officially bearish on the stock market. Equities plowed forward in the 2nd half of 2006 despite slowing growth, rising interest rates, inflation concerns, falling housing prices, a weakening dollar & an inverted yield curve. To me, this sounds too eerily similar to 2000.

So why the rally? 3 reasons:

1) Oil prices have been steadily falling since last summer
2) Corporate earnings continue to rise despite a slowing economy
3) Most investors believe the Fed will cut interest rates in 2007

The 3rd point was the most important (and most intriguing). Every time a bearish set of economic data was released in late 2006, the stock market shrugged it off since it heightened expectations of a Fed rate cut in 2007 (which stimulates growth). On the other hand, when positive data was released, the market still rallied. Thus, the stock market was going to rally no matter what the news!!!

This year should be different due to (a dirty word for investors) STAGFLATION. Yesterday’s Fed minutes indicated the presence of this double whammy: slowing growth AND rising inflation. These 2 phenomena rarely work in opposition. What this means is that the economy is slowing, but the Fed is unlikely to cut rates as long as inflation is an issue. This is very bad for the stock market and, to a lesser extent, the bond market.

The inverted yield curve (where short-term rates are higher than long-term rates) is also still an issue. In 1996, authors Estrella and Mishkin released a famous Fed study that developed a probability table about how likely a recession would be 4 quarters later, given a particular level of the yield curve spread. Their study accurately predicted the stock market crash in 2001 when the yield curve was inverted one year earlier.

The last few months, the spread between the 3-month & 10-year bonds has been -0.40% indicating a ~40% chance of a recession.

Even barring a full-fledged bear market, it's notable that the Dow has now gone over 1000 trading days without even a 10% correction. The current advance is among the 3 longest uncorrected advances on record. The table below indicates all prior instances where the Dow advanced more than 600 trading days without a 10% correction, along with the price/peak earnings ratio of the S&P 500 and the 10-year Treasury bond yield at the market high, and the extent of the ensuing decline.

This rally cannot ignore all these deteriorating economic conditions forever! If you think the stock market will keep plugging along, you’re certainly not alone. But several of the current bearish economic indicators must disappear for this to happen.

In a few days, I’ll share my “Bearish” stock & bond picks for 2007 that should perform well in a struggling environment (if you agree with my predictions!)