How To Protect Your Portfolio In A Bear Market

Economic uncertainty in emerging markets and steeply rising interest rates in the U.S. created plenty of concerns among global investors in the past week. Nobody knows for certain how these factors will affect stock markets in the coming days, but the fact remains that the stock market is inherently volatile and unpredictable.

A bear market is coming sooner or later, that’s just the way financial markets work, and investors need to be prepared for all kinds of scenarios.

Even the smartest professionals with massive amounts of intellectual and financial resources fail miserably in their attempts to forecast bull and bear markets.

As opposed to making market predictions, relying on objectively quantified variables with a solid track record of performance is a far sounder approach to protecting your capital through the ups and downs in the markets.

The following paragraphs will introduce 3 different quantitative systems based on trend following, earnings expectations, and relative strength. None of these systems is perfect or infallible, but the evidence shows that they can be remarkably effective at providing market protection through all kinds of environments.

Importantly, these systems are entirely rules-based, and they don’t involve any kind of market forecast or prediction whatsoever. The main idea is that you can reduce your downside risk in bear markets by relying on cold-hard data and observable indicators.

The Trend Is Your Friend

One of the most popular sayings in the market is “the trend is your friend”. Even if that is a cliché, that doesn’t make it any less true. There is plenty of statistical evidence proving that investors can optimize the risk vs. return equation in their portfolio and avoid big drawdowns by following the main trends in asset prices.

The following system is remarkably simple, yet effective. The market is considered to be in an uptrend if the slope in the 200-day moving average in the SPDR S&P 500 (SPY) is positive in the past 10 days. Conversely, if the slope in the 200-day moving average is negative in the index-tracking ETF over the past 10 days, then markets are considered to be in a downtrend.

The system only buys the SPDR S&P 500 when it’s in an uptrend, and it remains in cash when the ETF is in a downtrend. The system makes any buy or sell decisions every 4 weeks, so it doesn’t require a lot of work, and trading expenses should be negligible.

how to protect your portfolio in a bear market

Data from S&P Global via Portfolio123

Since January of 1999, this system produced an annual return of 8.55% versus an annual return of 6.35% for a buy and hold strategy in the market-tracking ETF over the same period.

In other words, a $100,000 position invested in the trend following system in January of 1999 would have a current market value of $505,100 and the same amount of capital allocated to a buy and hold position in the SPDR S&P 500 would be worth $337,500.

Even more important, the maximum drawdown for the trend following system was 20.57% during the backest period versus a much larger drawdown of 55.42% for the buy and hold strategy.

The backest is indicating that this remarkably simple trend following system produces both higher returns and much smaller downside risk than a buy and hold strategy in the SPDR S&P 500 ETF.

Market Timing Based On Earnings Expectations

There is an almost infinite amount of fundamental variables to consider when making investment decisions, but earnings are clearly one of the most important return drivers for stocks. At the end of the day, a stock is simply a share in an ownership of a business, so earnings have a huge impact on stock prices.

This system basically buys and sells the SPDR S&P 500 Trust ETF based on earnings estimates for companies in the S&P 500 index. Since earnings estimates can be quite volatile, the system uses moving averages in earnings expectations to smooth the data and evaluate the main trends in those estimates.

Specifically: When the 5-day moving average of earnings estimates is above the 20-day moving average, meaning that earnings estimates are on the rise, the system is fully invested in the SPDR S&P 500 Trust ETF. On the other hand, when the 5-day moving average is below the 20-day moving average in earnings estimates, the system is completely allocated to cash.

Data from S&P Global via Portfolio123

Since January of 1999, this system gained nearly 429.75%, while the buy and hold strategy in the ETF gained a much smaller 237.52%. Even better, the maximum drawdown for the system was around 25.44% during the backtest period, while a buy and hold strategy in the SPDR S&P 500 Trust ETF had a maximum drawdown of 55.42%.

Earnings expectations have a big impact on stock prices, and the data indicates that investors have a lot to win in terms of increasing returns and reducing drawdowns by incorporating earnings expectations into their toolbox for investing decisions.

Asset Class Rotation Based On Relative Strength

Trend following is about evaluating the main price trends in an asset, so you are looking at the current price versus previous price levels for such asset in particular.

On the other hand, relative strength is about comparing different asset classes. Even if both stocks and bonds are in uptrends, we can compare the two asset classes in terms of their risk-adjusted returns to evaluate which one has superior relative strength.

Combining trend following and relative strength means investing only in assets that are rising in price over the long term, and also picking only the strongest names among the ones that are rising in price.

The following system rotates between 9 ETFs that represent some key asset classes.

  • SPDR S&P 500 for big stocks in the U.S.
  • iShares Russell 2000 ETF (IWM) for small U.S. stocks.
  • iShares MSCI EAFE ETF (EFA) for international stocks in developed markets.
  • iShares MSCI Emerging Markets ETF (EEM) for international stocks in emerging markets.
  • Invesco DB Commodity Index Tracking ETF (DBC) for a basket of commodities.
  • SPDR Gold Trust ETF (GLD) for gold.
  • Vanguard Real Estate ETF (VNQ) for REITs.
  • iShares 20+ Year Treasury Bond ETF (TLT) for long-term Treasury bonds.
  • iShares 1-3 Year Treasury Bond ETF (SHY) for short-term Treasury bonds.

In order to be eligible, an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. If no ETF is in an uptrend, the system goes for the safest asset in the group, which is the iShares 1-3 Year Treasury Bond ETF.

Among the ETFs that are in an uptrend, the system buys the top 3 with the highest relative strength. Relative strength is measured by a ranking system that considers volatility-adjusted returns over 3 and 6 months.

Since 2007 the system gained a cumulative 325.2%, more than double the 136.5% generated by a buy and hold strategy in SPDR S&P 500. The maximum drawdown for the system is around 14% versus more than 55% for a buy and hold position in the ETF that tracks the S&P 500 index.

Source: ETFreplay.

These three systems show how different quantitative methods can provide downside protection in a bear market without making any kind of market prediction or speculation whatsoever.

Even if you don’t replicate these kinds of systems, the information that these systems provide can be enormously valuable at analyzing market conditions and adjusting your portfolio risk level accordingly. At the end of the day, information is power, and the information provided by these kinds of quantitative systems can make a big impact on your capital over the long term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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