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Surviving a bear market

FEW will debate that the months ahead will be challenging, and that the extreme market volatility will continue. There are a number of steps you can take with your adviser - or on your own - to weather these changes.

The first thing to consider is that the cards are lining up for the US and European economies to backslide into recession. The Economic Cycle Research Institute is calling for two quarters of negative growth. The European sovereign debt crisis is like a wounded beast. The Federal Reserve doesn’t seem to be able to help, despite lowering short and long-term interest rates.

But a more telling indicator might be the gold-to-copper ratio, which is diligently tracked by Jack Ablin, US portfolio strategist at Harris Private Bank in Chicago.

Copper, which is linked to the construction industry and economic growth in general, tends to underperform gold if a downturn is imminent, Ablin has found. “Over the past six months, copper has underperformed gold by 22%, suggesting an economy in reverse,” he says.

“Now that the Fed is out of ammunition, it’s unlikely that the central bank will help spur growth,” Ablin wrote in his October 4 market outlook.

Of course, economists’ tarot cards are not precise. It could happen that the Europeans could figure out a grand solution to their debt woes, recapitalise their banks or buy up the bad debt. Washington may come up with a way to unfreeze the glacial housing and market. Job growth may return. Then again, I could be rabidly optimistic.

Here’s what you should consider in the interim:

Get your bear-market strategy in order

If you want to invest in stocks, bear markets offer bargains, so you should be buying high-quality stocks as they dip. Look for companies that pay dividends. If you don’t want to make big purchases, invest gradually through dividend-reinvestment plans that provide commission-free stock repurchases.

Get your cash-management plan in order

Cash used to be king until rates fell to around our toes. That doesn’t mean you can’t find some yield. Focus on your short-term needs: emergency funds, out-of-pocket insurance expenses, looming tax bills. For years I kept my liquid savings in a money-market mutual fund. No longer.

When the yield recently dropped to zero, I transferred my family’s money into a FDIC-insured money-market account. I was able to find a bank paying 0.99% compounded daily. I know that yield stinks, but now I won’t have to worry if my money fund is exposed to European debt. I keep a year’s worth of cash to cover expenses like property-tax bills in this account.

Get your retirement accounts funded

Look to your 401(k). Don’t stop investing simply because the market is down. You can buy more shares at lower prices when the market dips. The best way is to gain broad exposure through index mutual funds and ETFs like the Vanguard Total World Stock Index exchange-traded fund or Vanguard Emerging Markets Stock Index fund. This may present a good opportunity to increase your exposure to companies in developing countries.

Protect your downside

Do you have college-tuition payments coming up or saving for a home down payment? Then you have no business being in stocks. Search nationally for an insured certificate of deposit through bankrate.com. Again, the yields will be dismal, but you won’t lose anything.

Tell your adviser the truth

If your risk tolerance is rising, you need to communicate that to your adviser now. The tough question is how much you can afford to lose. Is it 10%, 20% or nothing? If you are retiring soon, then ask your adviser to hedge your portfolio against stock losses. You can do this with individual options contracts for single stocks or bear-market funds like the ProShares Short S&P 500, which rise in value as stock indexes fall (and vice versa).

We live in a time in which there’s no reason to suffer losses from market downturns. Financial engineering does have a definite upside for those who hedge.

Who can you trust to protect you? A prudent adviser listens to your fears and aspirations equally. It shouldn’t matter what the market is doing if they are acting as a fiduciary in your best interests.  If they’re doing a good job, they shouldn’t have any need to characterise the market as a bull or bear.

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