I have waited for quite a while to write this brief article. I knew that I would write it at some point. However, because the Fed has been expanding our currency at an astounding rate, I had thought that the US stock markets might well "reflate" this year. I can't begin to tell you how many economists' writings I read each and every week. A significant number of them have been predicting that we will have a new bull market in the general equities market. Because I know that I do not know what will happen in the future, I have tried to keep an open mind about this. However, recent events and market movements have suggested to me that the risk of a serious market decline is now much higher than earlier this year (I wrote this a couple of days before June 26, 2008). Therefore, I think that it is now time to discuss some ways that investors can protect themselves or "hedge" against the possibility of a significant stock market or bond market decline.
If you are a brave soul, and if you carefully study individual stocks, you can consider taking short positions in various equities. If you sell a stock short, you must first make arrangements with your broker so that you can engage in short sales. You then borrow the shares of a particular stock from the broker, and you SELL the shares, even though you do not actually own them. A lot of people have a hard time understanding how one can legally sell something one does not actually own!
At some point, you will have to go into the market, repurchase shares of the stock which you sold, and you will have to return them to your broker. This is called closing out your short position. Anytime you sell a stock short, you are betting that the price of the stock you borrowed will go down. If it does, you can cover your position by buying it at a lower price. The difference between the price at which you sold the borrowed shares and the price at which you repurchased them is your profit. Jesse Livermore, the greatest trader EVER, made mega-millions "shorting" stocks at the time of the 1929 crash. Be warned: you need the guts of a riverboat gambler to utilize that strategy. The rewards can be great. On the other hand, the risk can be catastrophic if the stock price goes up when you thought it would go down. Most people should NOT engage in "shorting" individual stocks.
Fortunately, there are a number of ways in which more conservative investors can "hedge" their portfolios without having to engage in short sales of individual stocks. In particular there are several mutual funds (known as "bear funds") and ETFs (exchange traded funds) which attempt to "short the market" and thus allow ordinary investors to profit when the overall market goes down. These investment vehicles are also sometimes called inverse funds.
Other than owning bullion, my favorite way of "hedging" my family's stock investments is by owning shares in the Prudent Bear Fund (BEARX). This is a mutual fund which specializes in "shorting" the general stock markets. The fund also invests "on the long side" in gold and silver. If stocks go down significantly, BEARX usually goes up. This happened several times in June. BEARX is actively managed and has an excellent website with many helpful articles about economics and investing. Another bear market fund to consider is the Rydex Inverse S&P 500 Fund (RYURX). This fund is designed to go up when the S&P 500 declines. Just as with BEARX, you do not want to own RYURX during a bull market for general equities.
I have heard bear market funds described as "one trick ponies," and that is a reasonable analogy. Most bear funds have yielded flat or negative returns over long periods of time. That is why I do not consider them to be long-term investments. On the other hand, during times when the stock markets suffer significant corrections, then bear funds can be useful tools with which to "buffer" one's portfolio. This is especially true if you own "mainstream" stocks such as GM and GE. I have refrained from focusing on the bear market funds until now because I thought that there was at least a chance that the Fed's "money printing" since last September might ignite a stock market rally. However, based upon recent developments, I think that we are headed down. It's time to think about hedging one's portfolio, and bear funds provide a way to do it.
There are bear funds and ETFs which "short" particular sectors of the markets. For instance, one can use inverse funds to "short" stocks, real estate, gold, and oil. I don't think I would try "shorting" the latter two sectors right now! I also think that inverse funds which focus on narrow market sectors should only be used by experienced or professional investors, and only for periods of limited duration. One must have a specific plan as to when and for how long one wishes to own shares in a bear fund.
Another type of fund which can be used as a portfolio hedge is the Rydex Inverse Government Long Bond Strategy Fund (RYJUX). This fund is designed to go up when the price of the 30 year US Long Bond goes down. Like the other bear funds, it is not a "buy and hold" investment. Timing is everything!
In the world of bonds, if interest rates go down, bond prices strengthen. If rates go up, then bond prices go down. Thus far, we have experienced very LOW interest rates in US government bonds. For the past 20 years, we have been in a bull market for bonds. However, there have been some recent indications that this may be in the process of changing. PIMCO, the biggest bond investment company in the US, has recently announced that it is going to diversify into other areas because of its concerns about the bond markets. A number of very knowledgeable financial writers have also expressed concern that the bond market could be the "next domino to fall." If that were to occur, then one would expect RYJUX to go up in value. I am not certain that we are quite "there yet." However, if and when there are convincing signs that longer term U S government bond interest rates are on the upswing, then it will be a good bet that prices are heading down. At that point, RYJUX may be something you wish to consider.
There are many other "Bear" funds and inverse market funds which are available to investors. You can do a Google search and find most of them. However, before you buy any of them, it is incumbent upon you to do some research so that you will understand what the funds do, as well as the reasons why you might find them helpful. I believe that most investors should concentrate on identifying the current prevailing trend and "getting long" with that trend. That is why I do not own any shares in financial companies, home builders, real estate companies, retail merchants, or automobile manufacturing companies. However, if you do own stock in Home Depot, GM, Citigroup, or Lennar, you might want to consider investing in something which will go up in value if those companies, heaven forbid, continue to go down! I can't begin to tell you what a nice feeling it is when one's portfolio has just gone up when the Dow has dropped more than 358 points in one day!
Finally, this may be repetitive, but here goes:
Gold is the ultimate hedge against financial disaster!