How to protect your portfolio in a bear market

With recession fears rising, and evidence continuing to emerge that sentiment has truly shifted towards a bear market scenario, it is prudent to review your portfolio and take steps to ensure that you are well protected in this environment. Bull markets make everyone look like a genius, especially those who invest in high beta stocks, which typically tend to exhibit strong growth, lofty expectations, unreasonable valuations, and a variety of other poor fundamental qualities. None of this matters in bull markets, as these stocks ride the sentiment higher and higher. I'm not even talking about stocks like APPL or GOOG, both of which trade at lofty but not absurd valuations by some standards. I'm talking more about stocks like AMZN, CRM, LULU, and other companies that aren't even growing all that fast or, if they are, they trade at valuations that have tremendous room to come down if sentiment were to change. In tough economic times, stocks with a margin of safety, ideally in the form of cash or hard assets, tend to provide a backstop for how much a stock price can fall. A margin of safety can also be in the form of a company trading at a low valuation, which also happens to have earnings that are unlikely to drop much. Cheap stocks can and do get cheaper in bad market conditions, but they are unlikely to fall as much as expensive stocks.

With that in mind, let's take a look at a broad swath of companies that you should avoid to protect your portfolio in a bear market.

1) Avoid story stocks: Story stocks are stocks whose valuation is based soley on lofty future expectations. Examples today include Solar stocks, CRM, emerging market companies, and basically any company with a P/E in excess of 100x, or a P/S ratio great than 5-10. These stocks are already pricing in tremendous growth that may or may not come. Even if the story does work out eventually, these stocks are unlikely to see their multiples contract heavilly in bear markets as people discount the future, and in general grow more pessimistic. These stocks are also havens for retail investors who tend to panic more in bear markets, exacerbating downward moves. Story stocks always carry these risks, but negative market sentiment is always more likely to be the catalyst.

2) Avoid Wall Street Darlings with cyclical exposure: Stocks in this category would include internet stocks like MNST and AMZN, and even a company like APPL. All these companies are sensitive to economic conditions. If their revenue or margins fall, which often happens to economically sensitive companies in tough economic times, these stocks could get slammed even more than they have already.

3) Avoid Value Traps: trailing P/E multiples in an environment like this are highly misleading. Many companies that look cheap on an environment that no longer exists. The staffing stocks (KFY, HSII, and MNST), which I hae been short for several months now, are great examples of stocks that look deceptively cheap looking backwards, but expensive looking forward. Other examples would include retail companies, financial companies, bond insurers, and a variety of other companies whose future results are likely to look far worse than the results they have experienced in the recent past.

4) Avoid over-levered companies: Bankruptcies are not pretty and, rest assured, they will come. Companies with poor balance sheets are susceptible to going to zero if their businesses hiccup and they cannot pay off their debt. JAH, one of my favorite shorts, is an example of this kind of company: deceptively cheap, but if they run into issues the creditors will own them and the common shareholders will be left with nothing.

Stock corrections are painful for all investors, but especially amateur investors, who tend to be invested in exactly the wrong kind of stocks to be invested in in bear markets. If you have been going it on your own, or aggressively chasing the latest hot thing, strongly consider looking into time-tested mutual funds like HSFGX or FAIRX, which both have an excellent track-record in consistent, positive returns in all market environments.

The road ahead is fraught with perils. Many who did not learn their lesson from the internet boom, or the real estate bubble, are once again in harms way. Cautious investing to all.