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Surviving The Bear - By David D. Moenning

I am scheduled to present a seminar on risk management strategies to a group of financial planners and investment advisors. The sponsor thought the topic would be timely given the difficult times we face right now. Thus, I've been tasked to design a workshop to help financial services representatives navigate the rough seas.

So this weekend, while waiting to hear about Hank Paulson's plan on bailing out Fannie (FNM) and Freddie (FRE) - the Treasury Secretary is scheduled to hold a press briefing at 11:00 am eastern - I thought I'd lay out some of the key strategies investors need to survive a bear market.

Trader - Know Thyself
As with anything relating to the market, it is important to understand that each investor must utilize strategies that work within their emotional makeup. In short, it doesn't do much good to have the best strategy around if you are unable to emotionally handle the consequences of consistently following the strategy.

For example, I know for a fact that following something as simple as a 50-day moving average will keep you out of trouble during a bear market (defined as a decline of 20% or more in the S&P 500). However, such a plan has its pitfalls as the whipsaws incurred in following such a system will challenge your commitment on a consistent basis.

Another very easy method of market timing to follow involves selling when the S&P 500 falls by -7.2% from its most recent high and then buying when the market rises by +8.4% from its low. Sounds easy enough, right? And I'm here to tell you that this system is pretty successful too. According to NDR, from 7/19/66 through 9/5/08, following such a strategy would have produced annualized gains that are nearly 50% better than the yearly rate of return generated by the S&P 500 itself (+9.8% per year for the system vs. +6.6% per year for the S&P 500).

But here's the rub; only 53% of the trades are profitable. So, this means that when implementing this system you will feel "wrong" almost half the time. Can you handle that? Can you handle buying high and selling low four or five times in a row - because, that is exactly what happens when using this type of method? Thus, it is vital that you know what you can and can't handle from an emotional standpoint and play accordingly.

Understand the Environment
I have been managing other people's money since 1987 and one of the most important lessons I have learned over the past 21 years is the best way to beat the market over the long term is to "lose less" during the inevitable bear market declines. This brings us to my first point - understanding the environment.

For starters, it is paramount that you understand the type of beast you are dealing with. Cutting straight to the chase, during a severe bear market, such as we experienced in the mid 1970's and then again during 2000 - 2003 "tech bubble bear," the bears will get to everything eventually. So, during these severe bear markets, you must recognize that you, just like EVERYBODY ELSE, are going to lose money - it's just a question of how much. So, do yourself a favor and stop expecting to be the one investor out there that won't lose money in a bear market.
If you can't handle some losses during a bear market, consider moving to a bank-insured (hopefully) CD because the stock market goes up AND down. Thus, investors (as opposed to savers) understand that you need to be able to take the good with the bad.

Therefore, the game now becomes one of survival! In other words, you need to still be standing when the bear market ends (and rest assured that this too shall pass). In addition, it is extremely important to understand a new bull market WILL be born after the bears finish their work. So, if you can limit your losses during the bad times, you will have more money available to work for you during the next bull phase.

Survival Strategies
The vast majority of investors do not follow mechanical systems that, while frustrating, will work over the long haul. Thus, most investors manage their accounts using a reactionary approach and respond to what is happening in the market at the present time.

On that note, by now, almost everybody will admit that we've got a bear market on our hands. The point is that the goal right now is to lose the least amount possible until a new bull phase begins. How do you accomplish this, you ask? Here are a few strategies to consider implementing right now:

Do Less: This is NOT the time to be hyperactive with your investments.

Raise Some Cash: Remember to "sell to the sleeping point" as bear markets are part of the game. And in the immortal words of Robert Prechter, "cash is good because it gives you time to think." There is no need to be fully invested all the time. So, consider raising cash into bear market rallies. Having some cash in your account (I've currently got between 30% - 50% in cash across the board right now) means (1) you are likely to lose less during any further declines and (2) it keeps some powder dry to put to work when conditions improve.

Play Smaller: Make your bear market bets small ones. These are volatile times, so no need to be a hero and bet the ranch.

Don't Chase: There are rallies in bear markets and there are stocks that go up. However, it is a cardinal sin to "chase" (buying after a big run) anything higher during bear markets.

Don't Panic: Check your emotions at the door and try like the dickens not to panic when things "feel" bad. As the gang on CNBC's Fast Money likes to say, this is the time to "buy the dips and sell the rips." However, you'd best be mighty nimble if you are going to play this game.

Don't be Fooled by Dead Cat Bounces: Be aware that big rallies (aka dead cat bounces) occur frequently during bear markets when things become too oversold. These moves are generally short and sharp, and usually give way to another leg down.

Look For New Leadership: Since you may have some time on your hands, spend some of it looking for the new leaders. Remember, the leaders of the old bull market are unlikely to lead during the next bull move. Therefore, stop looking at energy and materials and start focusing on the new leaders such as health care.

Be Ready!
Finally, it is vital that you are ready for the miserable bear market phase to suddenly and without warning, morph into a new bull market. Remember, the stock market is a discounting mechanism that purportedly looks ahead 6 - 9 months. And since, according to Ned Davis Research, the majority of bull market returns occur during the first one-third of a bull market, it pays to recognize when to play the game again.

How will you know that it is safe to get back into the pool? In last week's report, we detailed one of our favorite bull market indicators - the breadth surge - or what we called "THE Buy Signal." In light of the fact that nearly all bull markets are either preceded or accompanied by a breadth surge, it is probably a good idea to "get ready to buy" when this signal is given. And don't worry; we'll be sure to alert you when the signal occurs.

This Just In
As expected, Fannie Mae (FNM) and Freddie Mac (FRE) are being taken over by the Federal Housing Finance Agency. The wires state that the Treasury Department will make periodic investments in Fannie and Freddie (which together back up 50% of the mortgages in the U.S.) via the purchase of preferred equity and warrants. The common and preferred stock will remain but the dividends will be eliminated.

While we are merely speculating here, this move may provide for a nice bounce on Monday morning because (1) the government has once again agreed to bail out what could have been a problem of epic proportions for the banking system/economy/markets and (2) it removes a great deal of uncertainty in the markets.

David Moenning, Editor Top Gun Trader Alert Service