Connecting the Dots

Cracks in Earnings Foundation and Bear Market Strategies

December 1, 2015

“Scoreboard, baby.”
—Rick Neuheisel, college football coach

I talk to a lot of investors, and most feel so emboldened from the red-hot October rally that concepts like risk management and cash seem like pastimes for investment idiots.

The only thing that matters to many investors is the Wall Street scoreboard, which shows the bulls in the lead. However, the bears look like they may soon deliver an upset victory.

Here’s what I’m talking about.

The revised GDP numbers were released last week, and they showed that the US economy grew by 2.1% in the third quarter.

But a big chunk of that 2.1% growth was from a buildup in business inventories; businesses accumulated $90.2 billion worth of inventories, up from the preliminary $56.8 billion reported in October.

Remember, businesses accumulate inventory for one of two reasons: (1) a voluntary accumulation in anticipation of an avalanche of orders, or (2) an involuntary accumulation as a result of disappointing sales.

Given the sales warnings we’ve heard from a growing line of retailers—such as Macy’s, Nordstrom, Walmart, and Tiffany’s—which of the above two reasons do you think explains the inventory buildup?

More importantly, the trend for nominal (unadjusted) GDP growth has turned negative. The last time that occurred was in 2009, in the middle of the Financial Crisis.

The problem is that corporate earnings are falling, from a record $106 in 2014 to $95.40, a not-insignificant 10% decline. Moreover, S&P 500 earnings have fallen for two consecutive quarters and are expected to fall in the fourth quarter too.

Despite the earnings recession, the see-no-evil crowd has boosted valuations to historically high levels; the trailing 12-month P/E ratio of the S&P 500 is 22.7.

Yup, almost 23 times earnings.

That’s high enough to raise red flags all by itself, but it is especially troubling because high valuations generally occur during periods of rising—not falling—corporate earnings.

High valuations combined with shrinking profits are a dangerous cocktail that should scare the pants off anyone.

I’m not suggesting you should rush out and sell all your stocks tomorrow morning, but I strongly suggest that you have a clear strategy to protect your portfolio when the bears take the lead on the Wall Street scoreboard.

Bear Market Strategy #1: Short Selling

When you buy a stock, you are betting that it will go up. And when you sell a stock “short,” you are betting that it will go down.

To short sell a stock, your broker loans shares to you. The shares are sold, and the proceeds are credited to your account. Sooner or later, you must “close” the short by buying back the same number of shares and returning them to your broker. This is called “covering” your shorts.

If the price drops, you can buy back the stock at the lower price and make a profit on the difference. Conversely, if the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Bear Market Strategy #2: Inverse Funds and ETFs

Some mutual funds and exchange traded funds (ETFs) are designed to profit from falling stock prices.

For example, ProShares Short QQQ (PSQ) is designed to track the inverse of the daily performance of the 100 largest domestic and international non-financial companies listed on the tech-heavy NASDAQ. So for every 10% the Nasdaq 100 drops, the ETF is meant to go up 10%. Of course, the opposite can happen: If the index rises 10%, the ETF could drop 10%.

Bear Market Strategy #3: Put Options

Investing in put options is a low-cost way to profit from falling prices.

A put option contract gives its owner the right, but not the obligation, to sell a specific number of shares of an underlying stock at a specific price within a specific time. You can buy put options on everything from Microsoft to China Mobile, to General Motors.

If the underlying stock's price falls while you own the puts, the value of your options will likely go up significantly. What happens if the stock goes up? Then your put options could go down in value and potentially expire without being worth anything.

The key is that you can only lose as much as you paid for the options, while your profit potential has no ceiling.

Now, don’t run out and implement any of these three strategies right away. They all entail substantial risk, and timing is everything. However, my point is that there are strategies available to help you grow your portfolio when things turn ugly.

And they will.

If you want to learn more about using these three Bear Market Strategies successfully, as my subscribers have done many times, give my monthly newsletter Rational Bear a risk-free try.

Tony Sagami
Tony Sagami

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