Bear-Market Portfolio Design

Adam Hamilton     November 15, 2002     3985 Words


Welcome to the bear market.


While such a statement was considered ultra-heretical and worthy of intellectual stoning-to-death not too long ago, today after 32 agonizing months and trillions of dollars of horrific losses the realization is setting in.  Tens of millions of investors, finally bursting free from the shackles of denial that blinded them for years, now understand that a humdinger of a bear market has truly descended upon us.


If you have any doubts that we are languishing in a once-in-three generation Great Bear market, the following graph should help dispel them.  We originally published this comparison of dire warnings on August 25th, 2000 in “To Crash or Not to Crash” when the NASDAQ was still trading above 4000.  Since then, this mega-bear has gleefully flayed the living flesh off countless unprepared investors.



The raw level of capital carnage we have witnessed since the summer of 2000 in the US equity markets is stunning.  Just as in 1929 a boom evolved into a speculative mania, spawning a rare supercycle bubble top utterly disconnected from fundamental reality.  The festering bubble burst giving way to the bust in which we are suffering now.  The parallels between our post-NASDAQ 2000 experience and the infamous Great Crash of 1929 aftermath are uncanny.


The NASDAQ and the general US equity markets are now experiencing a Long Valuation Wave mean reversion, tumbling down to some low undervalued P/E level.  While we have certainly already fallen far, it is still a lot farther down to fundamentally-undervalued levels based on current US corporate earnings power.


As crazy as it sounds, based on past bubble-bust precedent and current earnings, the US markets won’t even reach fair value, let alone undervalued bottoming levels, until 400ish on the S&P 500, 5000ish on the Dow 30, and 400ish on the NASDAQ Composite!  Ouch.


While it does feel like we have suffered a lot already, there is a 95%+ probability this Great Bear is just getting started in its hellish quest to force equity valuations back under fair value.  The worst is yet to come!


While I don’t like bear markets any more than any other investor, I do realize that as a mere mortal I can’t even hope to change the reality in which we now sojourn of having to unwind the speculative excesses of the preceding stock mania.  The die has already been cast, and you and I as investors face the stark choice of adapting to bear-market conditions or being utterly annihilated by the Great Bear.


Since building a fortune from nothing is such incredibly hard work, I think the wise choice to make is to adapt.  Rather than face certain doom, why not try and preserve and grow our capital through these chaotic market conditions and patiently await the better days that certainly lie somewhere ahead?


Growing capital in a bear market is vastly more difficult than in a bull market.  As the bull gallops all one has to do is buy a stock, almost any stock, and ride it up.  As the Wall Street Journal has proved, even haphazardly throwing darts at a newspaper page on the pub wall to pick random stocks can beat the experts in a bull market!

On the other hand few winners emerge out of bear-market carnage.  Bear-market investing is so challenging that the great majority of investors, who cannot suppress their own dangerous emotions of greed and fear, painfully witness their capital being ground into dust. 


Most bull-market investment strategies like “Buy and Hold” and “Buy the Dips” prove to be suicidal in bear-market environments.  The Great Bear creates countless capital martyrs who are crushed by the titanic forces to which they failed to learn to adapt.


Since we invariably receive many questions on bear-market portfolio design, I would like to offer some thoughts on this important subject this week.


I believe the core wisdom underlying prudent bear-market portfolio design is not a recent innovation, but ancient wisdom from millennia past.  Thirty centuries ago ancient Israeli King Solomon, one of the wisest men in all of history, uttered these fateful words…


“Cast your bread upon the waters, for you will find it after many days.  Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.”  Ecclesiastes 11:1-2, King Solomon, ca 1000 BC


At this stage in our current Great Bear I certainly don’t have to try and convince you that bear markets are exceedingly dangerous investment environments!  King Solomon, while articulating the basis of modern portfolio theory long ago, wisely pointed out that we shouldn’t bet all our capital on one horse. 


A prudently-diversified portfolio has the highest probability of successfully weathering the raging market storms, especially in chaotic bear-market environments.  While in a bull market you can sometimes ignore diversification and still earn money, in a bear market you should always divide up your capital 7 or 8 ways.  With this kind of bear-market diversification any one disaster, like tech stocks, cannot torpedo your entire portfolio because you only had 1/7th or 1/8th of your capital deployed there.


Remember that your first mission for bear-market investing is not to make money, but to simply preserve the capital with which you have already been entrusted.  The Great Bear will do everything in its power, attack every chink in your spiritual, intellectual, and financial armor, to get you to make a lethal mistake and flush your hard-earned investments down the toilet.  You have to first preserve what you have, through prudent diversification, and only then consider hunting bear-market returns.


In order to help decide how to divide up your capital, envision building bear-market portfolios based on a pyramid structure.  The humble pyramid, while geometrically simple, has proved to be the strongest structure men have ever been able to devise in all of human history.


The magnificent Great Pyramid on the Giza Plateau in Egypt will take your breath away when you gaze upon it with your own eyes.  Far more ancient than even Solomon, the stone monolith is believed to be forty-five centuries old.  It dazzled the ancient Greeks, amazed the Romans, entranced the early Europeans, and still stands proud today.  Its pyramidal structure is like no other for legendary stability and strength!


The Great Pyramid is still around today primarily because the builders intimately understood physics and had a fanatical zeal for perfectionism in the execution of their plan.  They built the strongest, most solid foundation level of stones first and then built up from there.  Without a stable foundation, the pyramid would have collapsed in disaster when the higher levels were added.


The foundation of a prudent bear-market portfolio, like the Great Pyramid, is everything.  Higher levels of capital deployment are only stable if built upon the solid footing of well-constructed early levels.  Our optimal bear-market portfolio design closely follows these ancient principles.


We see the 7 or 8-way diversification lying across four major categories in a bear-market portfolio. 


First the rock-solid Foundation is laid, then Investments are added, then Speculative Investments on top of those, and finally pure Speculations.  Within these four strategic portfolio categories investors can adjust their allocations based on whether they are a true patient long-term investor or an adrenaline-junkie short-term speculator.


The higher on the Bear-Market Portfolio Pyramid one climbs, the greater the risks of capital loss and the higher the potential returns.



If you deploy Solomon’s 7 or 8 portions across these four strategic asset groups, odds are you will emerge from this brutal Great Bear market relatively unscathed.  Heck, you might even make a little bit of money!


At Zeal this year, our real-world real-time actual in-and-out stock trades recommended to our subscribers in our Zeal Intelligence newsletter have been pretty good for a brutal bear market.  As of the end of Q3 2002, we have been blessed with an average realized gain on our stocks of 58.6%.  Using the very same bear-market portfolio theory discussed in this essay, we were blessed with beating the NASDAQ composite by 98.5% thus far in 2002.


So it is possible to make money investing and speculating in bear-market environments, as many contrarians and value-oriented folks continue to prove worldwide.  I hope these bear-market portfolio design ideas will help you decide on your strategic capital allocations so you too can preserve and enhance your scarce capital through these difficult times.


The pyramid above represents your entire treasure chest of liquid investment and speculation capital, including all financial assets you own that you consider investments.  It does not include illiquid specialized assets like your house, cars, or collectibles that you believe have some investment value, only financial assets that you can buy or sell instantly in the world capital markets.


One of the great attributes of this theory of bear-market portfolio design is it scales across different capital levels beautifully.  Whether you are already entrusted with great wealth or on your way, this portfolio framework is equally valuable.  If you can deploy between $10k-$10m of liquid assets, you can use the Bear-Market Portfolio Pyramid as a strategic guide to divide up your scarce capital 7 or 8 ways to implement Solomon’s ancient investing wisdom.


Now that you understand the overarching strategic framework, some thoughts on the pyramid’s Foundation, Investments, Speculative Investments, and pure Speculations are in order.


Like the Great Pyramid a great investment portfolio can only be built on a great foundation.  If your portfolio has a strong foundation your capital can weather any conceivable storm.  If your portfolio has a weak foundation your capital is as good as gone once the first big nonlinear discontinuity buffets the markets.  Your foundation is everything!


Contrary to the oxymoronic “conventional wisdom” of these strange times, but right in line with centuries of historical investment wisdom, the foundation of every investment portfolio should be physical gold.  That’s right, gold!  We’re talking physical gold in your own immediate control and possession, not stored with some faceless third party.


Unlike paper money, stocks, and bonds, gold has legendary intrinsic value.  Gold has been valuable on its own merits for six thousand years of human history and it will still be valuable tomorrow.  No matter what else happens in the markets gold will be the strong foundation supporting the rest of your capital.  No storm is too great for gold, as its allure and timeless value have outlasted every single currency, stock, and bond in world history.


Gold is really easy to buy in the form of one-ounce nationally-minted coins like the bullion US Gold Eagles so popular today.  For much more information on gold investing, please skim my “Gold Investing 101” essay. 


In addition to gold, physical silver may also be considered foundation-grade, although it is much more speculative than gold. 


Cash will also do in a pinch, although currency is never a truly secure holding.  Just ask the now wiped-out middle-class savers in Argentina who thought their US dollar deposits with world-class American banks were safe.  Instead their government betrayed them and forced the conversion of their dollars into pesos this year, raping their lives’ savings and destroying their families’ futures. 


Only physical gold under your immediate control offers the ultimate in protection, not fiat currencies.


As an added bonus gold itself has embarked on a glorious new bull market, so not only will you preserve your capital through absolutely anything the Great Bear can throw at you, but you will probably earn a fantastic return in the coming years as well!  If you don’t already own physical gold, you need to go buy some today.


After your Foundation is securely in place, you are ready to build the next level of your pyramid.  This is the largest strategic allocation area for investors, true Investments.


Since the vast majority of stocks plunge in a bear market, investing is quite a challenge.  The only investors who consistently make money are the hardcore value-style contrarians like Warren Buffett, who refuse to buy any company unless it is fundamentally undervalued in terms of its earnings (low P/E ratio), dividends (high dividend yield), and cashflows (lots of cash earned for shareholders).  Undervalued stocks must be undervalued today based on current fundamentals, not some projected but yet unknown future fundamentals.


Fundamentally-undervalued investments generally take 3-5 years to mature, so one has to be very patient regarding this strategic portfolio section.  This is not the category to actively trade!


Unfortunately finding quality undervalued stocks is very difficult at this stage in the bear market.  At the bottom they will be everywhere, but for now they remain elusive.  We search for these stocks at Zeal all the time but don’t find them very often.  If you can uncover them yourself, muchos kudos to you!  If not, you may consider a quality value-stock mutual fund.  Look for elite money managers that have been running capital for at least 5 years and who have achieved consistently healthy annual returns (10%+) through both bull and bear-market years.


While cash really isn’t appropriate for a foundation, believe it or not it is amazingly potent as an investment!


Today people whine about low cash yields all the time, often under 1%.  They forget that cash is rapidly growing in value relative to falling stocks!  If you hold cash today, you will have the opportunity in a year or two to buy vastly more shares of a given stock than today simply because the stock has fallen in the interim. 


For example, if you sold Cisco at $80 in March 2000 and sat on cash for 3-4 years, you would have only earned 1% per year on your cash.  But if Cisco plummets to $2 at the ultimate bottom (a brash prediction I made in an October 6th, 2000 essay called “NASDAQ Neutron Bomb” when the company still traded at $56), someone who held low-yielding cash and waited to buy back in until near the bottom could have increased his ownership stake in Cisco by 40 times in the Great Bear!


Cash, as maligned as it is, is often the ultimate bear-market “investment” simply because it preserves your capital for the legendary bargains to come later near the bottom, when you can dramatically multiply your total equity holdings.  Please don’t overlook the power of cash!


Cash can be preserved for the ultimate bottoming-zone in the form of short-term (3-month) US Treasury Bills or short-term European government bonds to eke out a small return in the meantime.  In terms of money-market funds, only “Treasury Only” money-market funds are appropriate.  Because of huge systemic risks in these dangerous times, longer-term bonds, mortgage-backed bonds, corporate debt, and any other non-short-term-Treasury-type debt instruments should be zealously avoided.


After your Foundation and Investments are in place, you can start to consider layering in Speculative Investments.  These are not pure Vegas-style speculations, but instead are often quality companies already earning money that are just not fundamentally undervalued yet, but probably will be in the future.  Unproven companies who have never made money do not qualify, only sound going-concerns that have already proven their mettle in the past.


This strategic pyramid zone is the broadest in terms of what kinds of investments qualify.  Speculative investments include unprofitable stocks in any sector with good prospects for near-future profitability, natural-resources stocks like gold miners and oil drillers, and even high P/E stocks with good prospects for a surge in future earnings.


My personal favorite speculative investments are the gold and silver miners.  They are where we have spent most of our time at Zeal trading stocks in the past couple years and where we have been blessed with our 58.6% YTD return. 


Gold is definitely in a technical bull market and silver will probably soon follow.  Companies that mine these precious metals have enormous leverage to rising metals prices.  While their costs for chiseling the metals out of the bowels of the Earth are relatively fixed, as metals prices rise their selling price, and their profits, shoot up like rockets.  For a much more detailed discussion on metals stocks as speculative investments, please see my “Gold Stock Investing 101” essay.


Another speculative investment is mutual funds that specialize in shorting stocks.  Since the primary trend in a bear market is obviously down, shorting stocks makes great sense.  True short sales have unlimited risk if the markets move in the wrong direction so we consider those pure speculations.  But, if you buy a shorting mutual fund, the most you can lose is 100% if the fund goes bankrupt.  Through financial alchemy the unlimited risk in shorting stocks is capped at 100% when it is transferred to individual investors owning a short mutual fund.


Having a professional do your shorting for you eliminates a substantial amount of the risk you bear, so a short fund does qualify as a speculative investment.  Please realize that shorting is never a sure thing though.  The Japanese Nikkei 225 fell dramatically after its bubble burst in 1989 and then it suddenly started trading sideways for years even though it remained overvalued.  Caveat Venditor!


Once you have your Foundation laid, your conservative Investments in place, and some Speculative Investments deployed, you are finally ready for the most fun part of your portfolio, pure Speculations!


A speculation is a true Vegas-style gamble, just a bet and nothing more.  Speculations are very risky but offer the potential for immense rewards.  Speculations are only appropriate for risk capital!  Risk capital means money that you can afford to lose and would not shed a single tear or lose a moment’s sleep if it the markets vaporized it in an instant.


In the hellish crucible of World War I trench warfare, during the heaviest fighting the life expectancy of a soldier in the frontline trenches was only a few weeks.  The soldiers’ parents, sending their beloved sons off to die, had to say their final goodbyes on the sendoff, even though they hoped and prayed that their son would not be butchered.  Speculators must have this same sense of finality when they deploy their risk capital, wanting to see it again but ready to accept a complete 100% loss if the markets don’t cooperate.


Pure speculations include derivatives (options and futures), true short sales, ultra-short mutual funds, and buying the stock of any young unproven company who has never made a profit, whether they are a technology player or a gold miner.


Options are my personal favorite pure speculation, a brutal zero-sum game where one speculator faces off against another like financial gladiators in mortal combat.  Options have limited lifespans, and there is always one winner and one loser.  In order for you to win, you have to make the right bet and then have the courage to sell at the right time.  All your winnings are direct losses for your opponent, the other side of your trade, and vice versa.


Options are incredibly risky.  Something like 90% of all long options purchased expire worthless, so the risks are enormous.  But a good options trader can earn 50% to 500%+ on one trade in mere days, weeks, or months.  Thankfully if you limit your options speculations to buying options (as opposed to issuing, or “writing” them), the most you can ever lose on a trade is 100%.  There is not unlimited risk.


If you are interested in this ultimate speculation game, please see my earlier essays on it including the recent “Volatility Trading the QQQs 2”.  If you have the right temperament, risk capital, and enjoy a great challenge, options are a wondrous speculation opportunity.


Futures are also derivatives like options, but much more specialized.  Many futures trades have potentially unlimited risk, meaning you can lose more money than you originally paid to buy the futures contracts.  Great caution should be used in this arena, which can once again be really rewarding if you take the time to diligently learn the ropes and see how the game is played.


True short sales are also pure speculations.  They have advantages and disadvantages compared to put options, but they do carry unlimited risk.  If you short a stock today and tomorrow it somehow miraculously rallies, you can be on the hook for far more capital than you thought you initially risked.  Only accomplished professional traders should even consider short-selling individual stocks for themselves.


A great bear-market speculation for normal folks is the ultra-short funds.  An ultra-short fund is a mutual fund that leverages the market indices to the short side.  For example, if the NASDAQ 100 index fell 20% in a month, an ultra-short fund might double that gain, yielding a 40% positive return for fund investors.  While great speculative tools, I classify ultra-short funds as pure speculations because market timing is very important for these leveraged plays.  If you buy at the wrong time, bear-market rallies can wreak havoc on your capital that is trapped and leveraged to the short side.


Even if you are a conservative investor, please don’t totally overlook speculations.  They are also extremely valuable psychologically and intellectually!  They teach you about your own emotions of greed and fear, how the markets really work, and give you a constructive outlet to fulfill your innate desire to trade. 


Having a small portion of your portfolio dedicated to pure speculation will be a lot of fun for you and help ensure that you don’t give in to the temptation to trade your long-term positions lower on the pyramid.  Trade your speculations to your heart’s content, but don’t overtrade the crucial lower sections of the pyramid!


Whether you have a modest or multi-million dollar portfolio, prudently distributing your assets at least 7 or 8 ways among the 4 major strategic categories of Foundation, Investments, Speculative Investments, and Speculations can yield great benefits.  Not only will you preserve your capital through the ravages of the bear market, but you will have the opportunity to earn healthy returns as we await the once-in-three-generation mega-bargains lying ahead near the ultimate bottom.


As different categories of your portfolio experience differing performances, it is wise to rebalance your portfolio twice a year or so.  For example, if you are a conservative investor who did well in your 5% speculations allocation, your speculations now total more than 5% of your entire liquid portfolio.  Take your speculative winnings and spread them out in appropriate percentages to feed and nourish the lower categories of your Bear-Market Portfolio Pyramid.  If you don’t periodically reallocate, your pyramid will grow unbalanced and may ultimately crumble.


Finally, you may have noticed the conspicuous absence of long-term bonds above.  With interest rates at 40+ year lows, long-term bonds are extremely dangerous today.  Interest rates will rise sooner or later in response to either monetary inflation or increases in economic activity, and as they rise the principal of long-term bonds will be decimated.  The crucial dynamics of bond pricing are explained in “Revolt of the Long Bond”. 


Unless you are a talented and vigilant bond trader ready to buy or sell anytime, the immense risks to long-term bond principal from rising interest rates far exceed the higher yields they offer.  The only good bonds to own at historically-low interest-rate levels are very short-term Treasury Bills, even though they aren’t yielding much today.


The bottom line is any investor or speculator, regardless of their means, can benefit from a carefully-designed bear-market portfolio.  The Bear-Market Portfolio Pyramid presented above is just one idea, but I hope it offers some insights that will help you design your own personalized bear-market portfolio.


Remember, while times are tough now, the markets always move in cycles and this bear market won’t last forever.  If you can preserve and grow your scarce capital through the bear carnage today, you will be wonderfully positioned to buy the investment bargains of a lifetime after we emerge on the other side!


Adam Hamilton, CPA     November 15, 2002     Subscribe