Bear markets bring misery to most every investor. But there are times when collapses create investing legends.
In 2008, these legends were few and far between. Defaults ramped up. Banks failed. Individual investors piled up seemingly endless losses. Panic swept the market.
Since most investors have a "long only" bias – they invest in stocks, but don't bet against stocks they think will fall – the financial crisis obliterated the retirement accounts of millions of investors.
But a few smart investors turned this terrible situation into massive profits.
Take hedge-fund manager Michael Burry. Profiled in the book and movie, The Big Short, Burry made a name for himself as a value-stock investor while everyone else chased the growth stocks of the late 1990s dot-com bubble. Thanks to healthy returns, his hedge fund, Scion Capital, grew assets under management to about $600 million.
In 2003, Burry began to worry about the housing market. He saw how lenders had loosened their standards dramatically. He saw borrowers with low incomes and few assets use huge leverage to buy homes and cars they couldn't afford. The chances of default were not only likely, they were a certainty in his eyes.
By 2005, he was so confident in his analysis, he put his reputation on the line.
He bought credit default swaps – a type of insurance – on billions of dollars of subprime mortgage-backed securities and bonds of many financial companies that would be devastated if the real estate bubble burst. (Credit default swaps rise in value when bonds fall in value.)
At the time, no one understood the bet he was making. Even some of the big banks like Morgan Stanley and Citigroup either had no idea what he was talking about or told him that the market didn't exist. But eventually, with persistence, he was able to place his short bet by working with the banks to create custom swaps.
And as we all know, the housing bubble eventually burst.
Burry's swaps were worth a fortune. He liquidated most of his credit default position in 2007 and then exited the remaining swaps in early 2008 because he feared the effects of government intervention.
He made $100 million for himself and more than $700 million for investors... during a time when other hedge funds were wiped out.
We hear about stories like Burry's all the time, but most folks don't have the moxie (or capital) to make that substantial of a contrarian bet.
But I (Jeff Havenstein) am writing to you today urging you to expand your investing tool belt. Everyone should learn how to protect themselves from falling markets.
You can, of course, buy put options – this is one of the most common forms of protection for investors.
Even simpler is "shorting" stocks. Although it sounds a little more complicated than buying a stock, shorting can be used by just about any investor.
At the very least, you should know how to do it.
Short selling is simply a transaction that will earn you profits when a stock falls in price.
It's just like buying a stock, except that you do the transactions in reverse. First, you're going to borrow shares and sell them. Later, you'll buy the shares back to close the position. If you pay less to buy them back than what you received when you sold them, the difference is your profit.
In practice, your broker will worry about the details of borrowing the shares and buying them back. The transaction – which is sometimes called "going short" a stock – is as simple as a conventional stock purchase (what's sometimes referred to as "going long" a stock).
Having a few short positions will protect you in the event of a down market – or in today's case, if we see stock prices crash early next year on recession fears.
Many investors will short stocks more for portfolio insurance, rather than trying to earn a profit.
Shorting is something you should think about using in your own portfolio, just be sure to start small. Short just a few shares until you're more comfortable with the idea of shorting.
But even if you're not ready to start short selling yourself, you can look at what other investors are shorting to get an idea of what the market thinks is going to fall. The table below looks at short interest divided by shares outstanding...
Short interest is simply the number of shares sold short but not yet repurchased or covered. As you can see, investors are betting against consumer discretionary and health care.
We've regularly told Health & Wealth Bulletin readers to never follow the herd. When you do, you either miss out on the biggest gains or you let your portfolio get dragged down to huge losses.
Doc and I have written many times this year about how bullish we are in health care... and how this could be the start of a mega-bull market. Seeing so many investors betting against the sector shows where the herd is going... And it only makes me more bullish.
What We're Reading...
- Something different: New Zealand plans law to require Facebook, Google to pay for news.
Here's to our health, wealth, and a great retirement,
Jeff Havenstein with Dr. David Eifrig
December 7, 2022