Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part V. The Part of Tens

Chapter 23. Ten Ways to Profit in a Bear Market

IN THIS CHAPTER

Doing research on good stocks, dividends, and bond ratings

Considering shorting and margin

Looking at call and put options

Exercising patience

Bear markets are brutal when they hit. Ask any stock investor who was fully invested in stocks during 1973-1975, 2000-2002, or 2008. You relieve the pain from the carnage by vigorously pulling your lower lip up and over your forehead to shield your eyes from the ugliness. Fortunately, bear markets tend to be much shorter than bull markets, and if you’re properly diversified, you can get through without much damage.

For nimble investors, bear markets can provide opportunities to boost your portfolio and lay the groundwork for more long-term wealth-building. Here are ten ways to make bear markets very bear-able (and profitable).

Find Good Stocks to Buy

In a bear market, the stocks of both good and bad companies tend to go down. But bad stocks tend to stay down (or head into the dustbin of stock history if the underlying companies go bankrupt), while good stocks recover and get back on the growth track.

For the investor, the strategy is clear. If the stock of a good, profitable company goes down, that presents a buying opportunity. Translation: Good stuff is on sale! Here’s where some basic research yields some diamonds in the rough. When you find companies with good sales and profits and a good outlook (get some guidance from Chapter 8) and then you use some key ratios (such as the price-to-earnings ratio and others covered in Appendix B), you can uncover a great stock at a bargain price (thanks to that bear market).

Many forget that some of the greatest investors in history (such as Warren Buffett and John Templeton) have used bear markets to buy companies when their stocks fell to bargain levels. Why not you?

Hunt for Dividends

A dividend comes from a company’s net income, while the stock’s price is dictated by buying and selling in the stock market. If the stock’s price goes down because of selling yet the company is strong, still earning a profit, and still paying a dividend, it becomes a good buying opportunity for those seeking dividend income.

Say you have a $50 stock of a great company, and it has a $2.50 annual dividend. That means that you’re getting a dividend yield of 5 percent ($2.50 divided by $50 is a percentage yield of 5 percent). Say that it’s a brutal bear market and the stock price falls to $25 per share. In that case, the dividend yield would be much higher. If the stock is at $25 and the dividend is at $2.50, the dividend yield would be 10 percent because $2.50 is 10 percent of $25.

For more about investing for dividend income, check out Chapter 9.

Unearth Gems with Bond Ratings

As a bear market unfolds, the tough economic environment is like the tide that rolls back from the surf and reveals who still has swim trunks on and who doesn’t. A bear market usually occurs in tough economic times, and it reveals who has too much debt to deal with and who is doing a good job of managing their debt.

This is where the bond rating becomes valuable (or is it invaluable?). The bond rating is a widely viewed snapshot of a company’s creditworthiness. The rating is assigned by an independent bond rating agency (such as Moody’s or Standard & Poor’s). A rating of AAA is the highest rating available and signifies that the agency believes that the company has achieved the highest level of creditworthiness and is therefore the least risky to invest in (in terms of buying its bonds). The ratings of AAA, AA, and A are considered “investment-grade,” whereas ratings that are lower (such as in the Bs and Cs or worse) indicate poor creditworthiness (risky).

If the economy is in bad shape (recession or worse) and stocks have been battered, and if you see a stock whose company has a bond rating of AAA, that may be a good buy! Flip to Chapter 9 for more information about bond ratings.

Rotate Your Sectors

Using exchange-traded funds (ETFs) with your stocks can be a good way to add diversification and use a sector rotation approach. Different sectors perform well during different times of the ebb and flow of the economic or business cycle.

When the economy is roaring along and growing, companies that offer big-ticket items such as autos, machinery, high technology, home improvement, and similar large purchases tend to do very well, and so do their stocks (these are referred to as cyclical stocks). Sectors that represent cyclical stocks include manufacturing and consumer discretionary. Basically, stocks of companies that sell big-ticket items or “wants” do well when the economy is growing and doing well.

However, when the economy looks like it’s sputtering and entering a recession, then it pays to switch to defensive stocks tied to human need, such as food and beverage (in the consumer staples sector), utilities, and the like.

For skittish investors, consumer staples and related defensive sectors are the place to be during an economic recession and a bearish stock market. Aggressive investors that like to be contrarians may see battered sectors as a buying opportunity, anticipating that those stocks will rally significantly as the economy returns to a growth path and a new bull market in stocks.

The bottom line is that rotating into sectors that will subsequently benefit from the next expected turn in the economy’s ebb and flow has been worth considering for many investors. How about you? See Chapter 13 for the scoop on sectors.

Go Short on Bad Stocks

Bear markets may be tough for good stocks, but they’re brutal to bad stocks. When bad stocks go down, they can keep falling and give you an opportunity to profit when they decline further.

When a bad stock (the underlying company is losing money, getting over-indebted, and so on) goes down, the stock often goes into a more severe decline as more and more investors look into it and discover the company’s shaky finances. Many folks would short the stock and profit when it continues plunging (I cover the mechanics of how to go short in Chapter 17).

Going short is a risky way to bet on a stock going down. If you’re wrong and the stock goes up, you have the potential for unlimited losses. A better way to speculate on a stock falling is to buy long-dated put options, which gives you the potential to profit if you’re right (that the stock will fall) but limits your losses if you’re wrong. I describe put options later in this chapter.

Carefully Use Margin

I typically don’t use margin, but if you use it wisely, it’s a powerful tool. Using it to acquire dividend-paying stocks after they’ve corrected can be a great tactic. Margin is using borrowed funds from your broker to buy securities (also referred to as a margin loan). Keep in mind that when you employ margin, you do add an element of speculation to the mix. Buying 100 shares of a dividend-paying stock with 100 percent of your own money is a great way to invest, but buying the same stock with margin adds risk to the situation. Chapter 17 goes into greater detail about the uses and risks of margin.

Notice the phrases “after they’ve corrected” and “dividend-paying stock.” Both phrases are intended to give you a better approach to your margin strategy. You would hate to use margin before the stock corrected or declined because the brokerage firm wants you to have enough “stock collateral,” so to speak. Using margin at the wrong time (when the stock is high and it subsequently falls) can be hazardous, but using margin to buy the stock after a significant fall is much less risky.

Buy a Call Option

A call option is a bet that a particular asset (such as a stock or an ETF) will rise in value in the short term. Buying call options is about speculating, not investing. I say this because a call option is a derivative, and it has a finite shelf life; it can expire worthless if you’re not careful.

The good part of a call option is that it can be inexpensive to buy and tends to be a very cheap vehicle at the bottom (bear market) of the stock market. This is where your contrarian side can kick in. If the stock price has been hammered but the company is in good shape (solid sales, profits, and so on), betting on a rebound for the company’s stock can be profitable.

Say the stock price for DEF, Inc., is at $23 per share. Consider buying a call option with a strike price of $25 that has a long-term expiration such as a year or longer. (In a call option, the strike price is the agreed-upon price at which the call buyer has the option but not the obligation to buy the underlying stock or ETF). Doing this means that you’re betting the stock will go up and meet or surpass the price of $25. If DEF goes to, say, $28 per share, then your call option could easily go up 100 percent or more in value and net you a tidy profit. Of course, if DEF stays down and doesn’t approach $25, then the call option will lose value. If DEF’s stock price doesn’t go to $25 during the entire time of the life of the call option, then the call option could expire worthless. Fortunately, the option didn’t cost that much money, so you probably didn’t lose much in the worst-case scenario. Depending on the strike price and the shelf life of the option, an option can cost as little as under $100.

Options are a form of speculating, not investing. With investing, time is on your side. But with options, time is against you because options have a finite life and can expire worthless. For more on wealth-building strategies with options, consider my book High-Level Investing For Dummies (Wiley).

Write a Covered Call Option

When you own a stock, especially an optionable stock, you have the ability to generate extra income from that position. The most obvious way to generate income from the stock (besides dividends) is to write a covered call option.

Writing a covered call means that you’re selling a call option against a stock you own; in other words, you accept an obligation to sell your stock to the buyer (or holder) of the call that you wrote at a specified price if the stock rises and meets or exceeds the strike price. In exchange, you receive income (referred to as the option premium). If the stock doesn’t rise to the option’s specified price during the life of the option (an option has a diminishing shelf life and an expiration date), then you’re able to keep both your stock and the income from doing (writing) the call option.

Writing covered call options is a relatively safe way to boost the yield on your stock position by up to 5 percent, 7 percent, and even more than 10 percent depending on market conditions. Keep in mind, though, that the downside of writing a covered call is that you may be obligated to sell your stock at the option’s specified price (referred to as the strike price), and you forgo the opportunity to make gains above that specified price. But done right, a covered call option can be a virtually risk-free strategy. Find out more about covered call writing in my book High-Level Investing For Dummies (Wiley).

Write a Put Option to Generate Income

Writing a put option obligates you (the put writer) to buy 100 shares of a stock (or ETF) at a specific price during the period of time the option is active. If a stock you’d like to buy just fell and you’re interested in buying it, consider instead writing a put option on that same stock.

The put option provides you income (called the premium) while it obligates you to buy the underlying stock at the option’s agreed-upon price (called the strike price). But because you want to buy the stock anyway at the option’s strike price, it’s fine, and you get paid to do it too (the premium).

Writing put options is a great way to generate income at the bottom of a bear market. The only “risk” is that you may have to buy a stock you like. Cool! For more on writing put options, check out my book High-Level Investing For Dummies (Wiley).

Be Patient

If you’re going to retire ten years from now (or more), a bear market shouldn’t make you sweat. Good stocks come out of bear markets, and they’re usually ready for the subsequent bull market. So don’t be so quick to get out of a stock. Just keep monitoring the company for its vital statistics (growing sales and profits and so on), and if the company looks fine, then hang on. Keep collecting your dividend and hold the stock as it zigzags into the long-term horizon.