How to Make Money During the Next Bear Market

Bear markets can be a nightmare for investors, and can be an incredible opportunity to build your wealth. As long as you have the right mindset, you can make an incredible amount of money during the next bear market.

Bear markets occur when stock prices go down by 20% over at least 2 months. Imagine your net worth dropping by 20% tomorrow, and you can see why investors worry about bear markets.

Instead of framing it this way, imagine that stocks have gone on sale, and are now 20% cheaper than they were yesterday. Furthermore, if those stocks go back to the prices they were, you’ll realize a gain of 25%.

With the right strategy and a solid head on your shoulders, you can capitalize on the next bear market and make some serious money.

Track the Value of Markets

Don’t believe the talking heads – bear markets are impossible to predict. However, you can always see whether the stock market is overvalued.

Stock market valuations are measured by the price people are willing to pay for profits. This is called the price to earnings ratio. To learn more, check out my article on valuing stocks.

Google “S&P 500 Price to Earnings Ratio” to quickly see what the S&P 500 is trading for today. Multpl.com has an excellent S&P 500 graph shown below:

Currently, the S&P 500 is trading at 20.76x previous earnings. The median valuation is around 15x. Thus, the S&P 500 is trading at roughly 33% more than it’s historical average.

Another sanity check is price to forward earnings. Forward earnings are expected profits for the next 12 months, which is what investors care about.

A quick search for “S&P 500 Price to Forward Earnings Ratio” shows that the S&P 500 is trading at roughly 16x forward earnings, according to the Wall Street Journal. This is roughly 7% above the historical average.

Hedge to Cash In Overvalued Markets

Massive highs are followed by crushing lows. As the bull market grows, stocks will become pricier, giving them a harder landing once reality strikes. The more money you have in cash, the more you money you can make once the next bear market comes.

There’s no magic number for how much cash you should park on the sidelines based on valuations. You should only completely exit the market during extreme situations. Warren Buffett has completely exited the stock market one time in his entire career.

Most financial advisors recommend that you keep 10% – 20% of your portfolio in cash. Doing so allows you to take advantage of downturns. Too much cash will drain on your returns after inflation.

As of February 2019, Warren Buffett’s Berkshire Hathaway has roughly $100 billion in cash, which is 20% of their enterprise value. He’s on the higher end of the range, but is still investing cash in companies every quarter.

If the S&P 500 becomes more expensive, hedge more of your portfolio to cash. Trim investments in companies that are trading with heavy valuations, as they are typically the ones who suffer the most in a downturn.

Don’t Let FOMO Get The Best of You

How are bubbles created? Warren Buffett gave the perfect explanation:

“People start being interested in something because it’s going up, not because they understand it or anything else. But the guy next door, who they know is dumber than they are, is getting rich and they aren’t,” he said. “And their spouse is saying can’t you figure it out, too? It is so contagious. So that’s a permanent part of the system.”

Warren Buffett, September 2018

Fear of missing out, or FOMO, is a powerful drug. All bubbles come to a crashing end – from tech stocks in the late nineties, to cryptocurrencies in 2018. Don’t let FOMO ruin your portfolio.

Once again, this article on valuations can give you a high level sanity check to stock valuations to see if there is a bubble brewing.

Consider Shorting Overvalued Companies

There are two ways to capitalize on market downturns – one is by hedging to cash so you can buy great companies at a discount, and another is by shorting stocks and betting that they will go down.

This article explains shorting stocks, as well as the pros and cons. You can make a killing shorting stocks if you’re right, but your losses are infinite if you’re wrong.

You can be right that stocks are overvalued, but it can take years for the market to realize this. Focus on companies at extreme valuations, and exit your position once they go south to lock in your earnings.

Pull the Trigger Once the Bear Market Comes

You hedged more money to cash, and may have even shorted a couple companies. Now that the bear market has come, it’s time to make money and cash in.

Exit your short positions by buying out those stocks, and start converting your cash pile to stocks or ETFs such as the S&P 500. There should be a direct correlation between the price to earnings of the S&P 500 and the percentage of cash in your portfolio.

Investing during bear markets is easier said than done. Negativity will surround you, and the news will make you second guess every investment you consider.

Don’t listen to them. If a great company was worth investing at $20 per share, they’re a no brainer investment at $10 per share. These companies are on sale – keep reminding yourself that while you ignore the pessimism.

How to Make Money in the Next Bear Market – The Bottom Line

Bear markets are impossible to predict, and the 20% downturn can be an investor’s worst nightmare. Nobody likes to see their net worth drop by 20%.

But the next bear market is a great time to make money. Hedge to cash as markets become overvalued, don’t worry about missing out at the top of the market, and cash in by shorting overvalued companies and buying stocks that are on sale.

The best way to guarantee a solid investment return is to buy at the lowest price, and bear markets give you an excellent opportunity to accomplish that.