Five ETFs For the Coming Bear Market

Five ETFs For the Coming Bear Market

For two successive columns now, the JLI has been unreserved in his bearish long-term outlook for global equities markets. As noted previously, the “Relative Strength Indices” (RSI) of all the major exchanges are operating in perilously overbought territory, and P/E ratios are also at or near historic highs. Economists at Bank of America keep track of nineteen mostly inside-baseball statistical “triggers” for a bear market, and over the past three months eleven of them have been triggered. The arrival of the next bear market is, in the eyes of most seasoned pros out there, no longer so much a question of whether as a question of when. Which leaves only the question of how to weather the gloom.

Fortunately I am here to help, with five recommendations for ETFs to consider as part of a defensive portfolio — analyzed with strategy breakdowns, geek-out statistics galore, and more than a few helpful visuals. The entire column should take about fifteen minutes to read.

Before we even get started on this rundown, I would be remiss if I did not pay respectful column space to the openness of the very question of a looming pullback in stocks. Davin Kostin, a senior equities analyst at Goldman Sachs, has even recently coined the term “rational exuberance” in justifying a continued long-position strategy. His plausible argument centers on the need for large corporations to deploy their abnormally liquid short-term profits through equity reinvestment and stock buy-backs, both of which should of course continue to drive share prices higher — at least for as long as the abnormally liquid profits hold out. Recent sweeping changes to the tax code have, as noted in a prior column, also abetted the Street’s bullish tilt.

In the absence of these more localized contexts, however, the long-term structural indicators are significantly less encouraging. US unemployment- and interest rates are both at or near historic lows, thus denying the typical sources of low-hanging fruit for bolstering future earnings to match the present rise in share values. Any further increases in profitability will thus have to be fundamental rather than cyclical, and to this columnist it seems improbable (at best) to count on entire indices’ worth of diverse and sometimes rival companies to enjoy structural improvements in their bottom lines all at once. The Morningstar Fair Value Ratio (1.00=neutral) has US stock prices right now at a positively dizzying 1.11, a measly 3bp off its all-time historic high of 1.14. And Fair Value Ratios don’t hang around that far above 1.00 for very long — that’s what makes them fair in the first place. Clearly an investor without at least a contingency plan for shifting to more defensive portfolio positions in the near term would be wise to consider gathering one together post haste.

Without further ado, then, here are the five ETFs that the JLI is eyeing for that not-so-distant day when his longer equities stop out. Each has its own strategy, its own (often pretty decidedly unique) past performance, and its own advantages and drawbacks. None of them should be viewed as a magic bullet all by itself and, of course, none of the subsequent discussion should be taken as an actionable recommendation to buy. Always do your own research, and never trust the written word of a hack writer who is also so stupid that he eventually had to pull up stumps and move to Cambodia to hide from his own stupidity.


1. The Utilities Select Sector SPDR (Ticker: XLU)
12mo return: 5.45% (excluding dividend reinvestment)
Market cap (Mns) : 7,500
Expense ratio: 14bp
Altar score: 5.9
Market Edge rating: Avoid

Pros: Strong negative correlation w/broader indices
Reliable and attractive dividends
Flight to quality could inflate utilities artificially
Extremely low expenses, excellent market cap, small spread
Future of OPEC member-non-member agreement in doubt
Boring return pattern alleviates pressure to time the correction

Cons: Neither Altar score nor Market Edge are bullish
Lackluster performance in sideways markets
Many utilities beholden to energy prices

This fund, offered by State Street SPDR, seeks investment results corresponding generally to the price and yield performance of publicly traded equity securities of companies in the Utilities Select Sector Index. And it’s hardly surprising to see that a utility fund made our list, since flights-to-quality have always alighted at least partially on utilities. For the moment the sector is a significant laggard in both the US equities market and elsewhere around the world, but this seems largely to do with the historic “member-non-member agreement” to reduce oil production from Saudi Arabia to Russia. Energy prices have spiked in consequence, and since many utilities rely on hydrocarbons provided by signatories to the agreement, their share values have suffered along with their bottom lines. At all events, XLU has not been a darling of the ETF constellation, and any buy recommendation should be tempered to accommodate the absence of supporting expertise.

This being said, the JLI considers the future of the OPEC member-non-member agreement to be less than promising, particularly given that the non-member signatories have proven their capacity to operate with positive margins at a much higher output volume and a much lower price. The longer the agreement remains in place, the longer these lower-margin producers will experience unnecessarily lower sales volumes, for what appear at this point to be purely political motivations. Pressure to cheat the agreement, or abandon it altogether, will build from all quarters of the non-member hydrocarbon inventory, with no realistic backup plan to clear the remaining supply overhang in the sector. As energy prices stabilize or even fall, utility stocks should have no trouble returning to favor as a time-honored safe harbor in a turbulent capital market.

Negative correlation is of course the point of this entire column, and XLU is a strong historic performer in this regard, having nailed its theoretical inverse-return pattern in four of six recent corrections to the broader indices – one of them quite handsomely.

Moreover, utilities generally benefit from the anecdotal strength of their own reputation in bear markets, prompting many amateur investors to embrace utility positions in a near-total absence of justification from the market fundamentals — thus bidding up the price of the underlying securities in this fund. Add to these factors a strikingly low expense ratio, generous and predictable dividends, a narrow spread, and excellent market cap, and the inescapable conclusion is that an amateur investor who doesn’t mind lagging returns during good times could easily motivate a long position – even one that hadn’t been particularly close-hauled to the timing of any looming pullback market-wide.

JLI recommendation: Long, but at a relatively small percentage of one’s overall portfolio. Set unusually generous stops in anticipation of near-term volatility.


2. The iShares 20-year T-Bond fund (Ticker: TLT)

12mo return: 3.68% (excluding interest reinvestment)
Market cap (Mns) : 7,100
Expense ratio: 15bp
Altar score: N/A
Market Edge rating: Avoid

Pros: Near-perfect negative correlation over recent past
Reliable and attractive interest returns, tax free
Extremely low expenses, excellent market cap, small spread
Most recent year’s returns positive despite unattractive structural conditions

Cons: Flight to quality is unlikely to benefit the long bond
Low interest rates unlikely to last indefinitely, with hikes hurting existing bonds
Political risk is non-zero

“Anyone who recommends that you buy bonds when interest rates are this low, is someone you never have to listen to again.” –The JLI, two columns ago.

That’s … probably still true, particularly given that Treasuries have of late been tasked with the added burden of shouldering a non-zero risk of default, thanks to political uncertainty in Washington. With all these factors widely known and understood, the chance of a beneficial flight-to-quality response is far less likely in a bond-related ETF than with other safe harbors such as REITs and investor-owned utilities.

Still, if the objective is negative correlation with future bear markets, a long-bond fund has historically served as the kind of no-brainer that would make a person feel foolish for having missed out on it.

Again, the highlights:

Routine and tax-free interest settlements have always supported share values semi-independently of the news out of Capitol Hill, and will presumably continue to do so, and returns have managed to be positive over the past twelve months despite all the negative actors chronicled directly above.

The wildcards in considering TLT as a bear-market hedge would have to be, first, the triggers for the start of the bear market in question (which may or may not include a hike in interest rates), as well as the bear market’s subsequent duration after it is triggered. In cases where the incoming bear was invited across the threshold by the Fed, a long correction could afford the amateur investor the opportunity to watch-list TLT until the effect of the higher rates had been sufficiently baked in, and then assume a long position with a tight stop-sell value – to avoid having to watch for the first nearly inscrutable signs that the correction was over. In any other circumstances, particularly a correction that was triggered by inflation-dovish actors like a global upset, it seems difficult to recommend a bond fund of any kind, at least for now.

JLI recommendation: Watch, then diagnose the role of interest rate increases on any ensuing correction. If large, await a corresponding price correction in TLT, and then assume long position with tight stop-sell value.


3. The WisdomTree Dynamic Bearish U.S. Equity Fund (Ticker: DYB)

12mo return: 4.54%
Market cap (Mns) : 5
Expense ratio: 52bp
Altar score: N/A
Market Edge rating: N/A

Pros: Extremely stable through all phases of market cycle
Manages a consistently positive return
Near perfect negative correlation in the last significant pullback

Cons: Because it is an equity fund, there are little or no dividends
Low volatility limits upside in a true bear market
Alarmingly low market-cap, coupled with high expense ratio

Equity funds are one of the unsung heroes of bear markets, precisely because their equity is already locked and therefore cannot go up and down with the transitory whims of the wider investor class. They generally pay a plodding, boring return, and they generally keep paying it regardless of whether the broad market indices are up or down. Moreover, during the most recent market correction of any real magnitude – in early 2016 – DYB managed to perform to a near-perfect negative correlation, which would have made it a sterling target for jet-lagged investing, since recoveries in the broader markets are so widely publicized and easy to detect.

The JLI searched high and low for a well-capitalized and cheaply-run equity ETF, and came up empty – perhaps this is a good topic for a follow-up article – but the problem with this particular fund is that it is neither cheaply-run, nor well-capitalized. And the latter poses a particular concern, as it means that even relatively small buy or sell orders on the part of lunchpail types like us could literally move the market. Which is something you simply do not want to happen, ever, because the book will need to cover its entire margin through your personal bid-ask spread. This could make getting out of DYB at a profit quite a bit trickier than would otherwise be the case.

JLI recommendation: Keep your eyes peeled for other, better-capitalized equity ETFs with a similarly impressive track record of stability through broader corrections.

JLI backup recommendation: Set a good-til-canceled limit-buy order (the opposite of a stop sell) at the prevailing ask price on the day you’d like to buy. This would mean that you pay the ask price, despite the spread you saw when you checked in. If your buy order doesn’t trigger, walk away knowing that you didn’t stick yourself on the pike of an eleven dollar spread, the same way I did recently with a different security.


4. The ProShares Short S&P 500 Fund (Ticker: SH)

12mo return: -21.00%
Market cap (Mns) : 1,400
Expense ratio: 89bp
Altar score: N/A
Market Edge rating: Avoid

Pros: Perfect negative correlation by design
Well capitalized with a surprisingly small bid-ask spread
Less volatile than more popular double- and triple-inverse funds

Cons: Not designed for buy-and-hold investing
Will need to cover spread quickly before value of position deteriorates
Perfect correlation means an incorrect guess could be costly
Shorting is expensive, so expense ratios in short funds tend to be high

There was a time when, if an investor thought a market was about to go down, her only real play was to “short” the market: She’d call her broker and say, “Sell X shares of Y,” without actually owning X shares of Y, on the expectation that Y was about to go down precipitously. Then at a prearranged date in the future, she would buy them back to “cover her position,” and pocket the difference. (If you’ve seen the movie Trading Places, this is what Eddie Murphy and Dan Akroid did to the Frozen Concentrated Orange Juice market, in the film’s climactic scene: They sold shares of FCOJ that they didn’t actually own, at $142, when everyone else was trying to buy — and bought them back a few minutes of movie-time later at $29 when everyone else realized their mistake.)

This would have been, as you might imagine, a more-or-less literally insane thing for someone like you or me to do. If our hypothetical investor was wrong, and the price of Y went up instead of down, she would *still* need to cover her short, since she’d just finished selling something she didn’t actually have. Her downside risk would be literally unlimited.

Today, mercifully, an investor who thinks the market is about to correct has at her disposal the far safer option of buying a stake in someone else’s gamble – safer because the stake itself can be resold to someone who wants the same thing, later, if the first buyer timed it incorrectly. This is called a “short ETF,” and the way it works is really just that simple. The managers of the fund carry out the short described above, and the value of the available stakes in their gamble go up and down with whether or not they were right on any given day. As you might expect, the result is a fund whose performance looks like a mirror reflection of the market — with all the assurance, and all the risk, that appertains thereto.

The granddaddy in this product space (and incidentally one of the world’s oldest ETFs), is the ProShares Short S&P 500 fund. Indeed it was the JLI’s first-ever financial market play, acquired in early 2000. As inverse funds go it’s actually a fairly staid and stately specimen, with none of the leveraged derivative indexing that characterizes the much bolder and more volatile players in the space, some of which are designed to effectively double or even triple the opposite of whatever the market is doing on a given day.

Still, inverse funds are plenty risky. You won’t be asked to cover your short, but you might be pretty shocked by how much money you can lose if you haven’t timed the ensuing correction carefully enough. This point is driven home to you by your brokerage if you try to buy shares of this, or any, inverse fund, because the order screen includes an unfamiliar checkbox — with which you are made to acknowledge that what you’re doing is riskier than most people can comfortably tolerate.

What’s worse, inverse funds don’t do well under buy-and-hold conditions, because any move they make on one day is amplified geometrically if the market moves the same direction on the following day. This means that you can’t get in too far ahead of the correction, for fear of losing too much of your initial cost basis, and you can’t wait until everyone knows it’s a correction, either, because the share price will have been driven up too high.

JLI recommendation: Not for the financial-news-disinterested, and/or the faint of heart.


5. The iPath S&P Short-term Futures Fund (Ticker: VXX)

12mo return: -64.00%
Market cap (Mns) : 939
Expense ratio: 89bp
Altar score: N/A
Market Edge rating: N/A

Pros: Not dependent on inverse derivatives or other highly leveraged instruments
Magnitude of small market corrections amplified with large gains
Offers best chance of arrestingly high returns in a steep correction, w/limited risk

Cons: Sweet Jesus you’d better be right

There is one other way that an investor can benefit from a market correction, and that is by capitalizing on the inversion of the spot- and futures price of the assets whose values are declining. The iPath fund seeks to capitalize on this wedge by selling at the spot price and covering not with a short, but with futures.

A futures contract is just that: a contract to buy something, for a given price, at some point in the future. Ordinarily the price of a short-term futures contract will contain a certain amount of discounting, to account for the uncertainty that sellers may expect over time. (We could get nuked by North Korea before the sale can even go through, to pick one random and hopefully not too topical example.)

In a falling market, however, the opposite happens: The spot price quickly drops below the futures price, because the shoe of uncertainty is on the buyer’s foot instead. When this happens for long enough, a traditional short is rendered technically unnecessary, provided that the investor using this approach has enough clout to receive a third-party cover on its current sale, who is also willing to wait until the futures contract actually executes. And this is what iPath seeks to do.

The good news is that this strategy can pay extremely handsomely, over extremely short corrections (provided they’re steep enough) without as much dependency on split-second timing as with SH, above. But this cuts both ways, since the futures contracts must be purchased by the fund every day regardless of what the market is really doing. As a result, and despite the fact that the iPath fund doesn’t indulge in conventionally risky behaviors like derivatives-swapping, the losses in a continued bull market can be positively gob-smacking.

Worse, the instant the play became undeniably attractive, the nature of this particular fund’s strategy would prompt unusually wide bid-ask spreads, making it much harder for the typical investor to get in – and subsequently out – in a nimble enough fashion to finish in the black.

The one exception to this would be if the market undergoes a mild correction, followed without interruption by a much steeper one. Say, for example, that the S&P loses 1% of its value over a ten-trading-day span, and then 5% of its value over the next four trading days. In that scenario (and none other that I can think of, frankly), VXX would be an attractive middle-class play, since the investor could buy on day two of fourteen, cover the spread on day seven or eight, and then reel off a gigantic return with extremely tight stop-sell values over the remainder of the correction.

JLI recommendation: Unless the broader markets are experiencing a gradual decline followed without interruption by a steep one, the timing and spread issues are just too risky and too expensive for me to advise anyone to buy this one. Maybe a few shares for the entertainment value alone – but even those would have to be carefully timed. VXX’s three-year return is, if you can believe it,  (96%), meaning that a $1000 purchase in January of 2015 would today be worth $40. Yikes.


Well, there you have it. Five ETFs to at least watch as the calendar inches on toward 1 May, and the stability of global capital begins to creak and totter. If nothing else, I hope this rundown afforded a few entertaining hypotheticals for those distant what-if days, when all of this halcyon black ink starts to look nostalgic for how easy it has been.


Happy hunting.

Dave O’Gorman
The Jet-Lagged Investor
Phnom Penh, Cambodia

Article uploaded on 27 January, 2018
9:30PM Indochina time,
9:30AM Eastern Standard Time

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