If you’ve been wondering what a bear market feels like, this is it. The bear is here.
But that doesn’t mean you have to panic. It doesn’t even mean you have to lose money when all is said and done. There are strategies that can help preserve your capital in a bear market — and there are strategies for growing it.
Today we’ll look at the original downside protection strategy from the first ever hedge fund manager — who was also one of the greatest hedge fund managers ever.
But first, let’s talk bear markets. Why do we say a bear market is here for U.S. equities?
In the second week of December, U.S. financials officially entered a bear market, according to CNBC, after closing down a shade over 20 percent from their 52-week highs.
Stocks in the energy and materials sectors had already achieved bear market status by the 20% down measure, as had most of the FANG names.
But even if you consider the 20% designation to be arbitrary — and truth be told it kind of is — general conditions in U.S. equities right now have the smell and feel of a bear market, according to billionaire money manager Jeff Gundlach. As Gundlach recently told CNBC:
“I’m pretty sure this is a bear market. I mean, people like this definition of 20% down is a bear market, but that’s pretty arbitrary. I’ve been around for over 35 years in this business, and I’ve seen a number of bear markets, and it’s more about kind of how you lead into it, how it develops, and how the sentiment changes. And I think we’ve had pretty much all of the variables that characterize a bear market.”
There is also the performance of U.S. equities for December thus far. With the month more than half over, stocks are on pace for their worst December since 1931 — which occurred in the Great Depression!
That’s mildly depressing, but not entirely unexpected. Historically speaking, bear markets roll around every five years or so. We’ve gone 10 years since the last one.
Bear markets are typically short and unpleasant affairs — like a bad relationship that mercifully doesn’t last too long. The main objective with a bear market is to survive it — to come out the other side with both financial and mental capital intact.
But coming through a bear market fully intact, with both financial and mental capital preserved, is a harder job than it sounds. The temptation for many investors, when faced with a bear, is to either freeze or panic, or worse yet, to freeze until the bear market is almost over, and then panic at the low point.
The bearish backdrop is a great reason to talk about downside protection strategies.
One of the first and best downside protection strategies was devised by the original hedge fund manager, Alfred Winslow Jones.
Alfred Winslow Jones not only dreamed up the whole concept of hedge funds, he was one of the greatest money managers ever.
In the 34 years of running his hedge fund partnership, Jones had only three down years. In his first two decades of performance, from 1949 to 1968, Jones earned a cumulative return of roughly 5,000 percent, a result that would have turned $10,000 into $480,000 while crushing the market averages.
Alfred Winslow Jones was borne in Melbourne, Australia, and came to the United States when he was 4 years old. After an interesting and varied career that included a stint in the U.S. Foreign Service, a doctorate in sociology, and flirtation with becoming a Marxist — Jones became a journalist for Fortune magazine.
While doing research for a 1949 Fortune article titled “Fashions in Forecasting,” the breakthrough insight Alfred Winslow Jones had was that leverage and short selling — betting that stocks would fall rather than rise — could be used as a means of reducing risk, rather than increasing it.
In the 1940s, the pain of the 1929 stock market crash and the 1930s Great Depression decade was still fresh. Leverage (using borrowed money to buy stocks) and short-selling (wagering stocks would fall rather than rise) were seen as the tools of 1920s era speculators, too risky for responsible investing.
Alfred Winslow Jones discovered the opposite. He realized that, deployed properly, leverage and short-selling could — at least in theory — make the investing process safer and more profitable at the same time.
As Sebastian Mallaby recounts in his excellent biography of hedge fund industry legends, More Money Than God, Jones explained his philosophy with the following example via private prospectus in 1961:
In the example Jones used, two investors have equal stock-picking ability.
But the traditional investor does the traditional thing — goes 80% long stocks and holds 20% cash — while the “hedged” investor does something different.
In Jones’ example, the hedged investor uses leverage to double his total exposure to the market — from 100K to 200K — and then takes another aggressive step, pairing $130K worth of long stock investments with $70K worth of short positions (which profit when stocks fall rather than rise).
If the shorts are selected with care, the hedged investor can outperform the traditional investor in bull and bear markets alike.
In a bull market, the hedged investor loses money on their short picks — but they more than make up for it with greater gains on their increased long-side exposure.
And even better, in a bear market, the traditional investor can wind up in the red while the hedged investor still makes money, because the shorts gain more in value than the amount the longs decline!
This is why Alfred Winslow Jones referred to being “hedged” — the idea was to reduce overall levels of risk by hedging one’s bets, which was done through a careful leverage-and-short-selling combination.
The concept worked spectacularly for Jones and his investors. He started his partnership in 1949 right before the Fortune article was published, raising $100K — of which $40K was Jones’ own money.
Nobody really paid attention to what Alfred Winslow Jones was doing — or how well he was doing — for another 17 years.
That changed in 1966 when another Fortune journalist, Carol Loomis, wrote a glowing article titled “The Jones Nobody Keeps Up With.”
After Jones’ methods were explained — with his 17-year track record to back them up — interest levels in the Jones technique exploded. Over the next three years, 130 hedge funds were formed — including Quantum Fund, one of the most successful hedge funds of the 20th century — and the hedge fund industry was born.
So how can you take advantage of Alfred Winslow Jones’ big insight?
Well, for the last 10 years or so, downside protection hasn’t been much of a worry. Markets rose and rose, and passive investing strategies seemed to dominate the market.
Now, though, the kind of downside protection used by Alfred Winslow Jones — the actual “hedging” of longs with a corresponding group of shorts — can have a lot more value. And one limited-risk way to get exposure to the short side of the market is with put options.
Short-selling is not easy. Without the proper training it can be dangerous. But by purchasing put options — a type of options contract that rises in value when an instrument falls in price — it is possible to see bear market gains on stock declines while limiting initial risk.
Using put options as tools to limit the risk, it thus becomes possible to devise bear market protection strategies in the style of the “hedged” approach Alfred Winslow Jones used, while limiting the strategy risk for investors who use them.
Selecting which stocks to be bearish on — and selecting the put option at the right time — is another tricky area that requires skill. We are working on this, too.
As you may know, we have done a lot of work on what we call “algorithmic volatility strategies” to identify — via easy-to-use software — stocks that are entering into bullish trends.
The next big step for our research team, a step which they are hard at work on as you read this, is deploying the same kind of algorithmic selection power to stocks entering into bearish trends — making them good candidates for a put option buy, and the use of a downside protection strategy like the one Alfred Winslow Jones used.
If you would like to have access to our “bear market protection” strategy once it’s ready — and it will be ready soon — there is an easy way to get it.
All of our Ideas by TradeSmith subscribers will have access to this strategy, and any other new Ideas by TradeSmith strategy we devise, as part of their subscription. And in the meantime, our existing long-side algorithmic volatility strategies are already doing great, as you can read about here.
Bear markets can be frightening and unpleasant. But you don’t have to fear them. With the right strategies, you can not only survive, but even thrive.
Alfred Winslow Jones, the father of the hedge fund industry, showed the way, and his ideas have merit to this day. We are working hard to bring you the power of those ideas, and others, with hedge fund-quality research and software.
Richard Smith, PhD
CEO & Founder, TradeStops