Dow 6,500 sounds a bit over the edge, but before you dismiss the idea, did you think it was possible for the Dow (AMEX: DIA) to tumble 43% in less than a year? Did you expect the Nasdaq (Nasdaq: QQQQ) to drop 80% after its 1999 peak? 

Stock market declines in excess of 30 % are a rare occasion. When they do happen, they usually mark a good buying opportunity. You could say that over the past half century we’ve been conditioned to believe that any significant drop in the stock market is an opportune time to buy. True to form, even investment stallions like Warren Buffett have splurged on stock shopping sprees recently.

However, this bear market dwarfs previous bears in terms of scope and downside potential. Buying into declining values is truly like catching the proverbial falling knife. Since Warren Buffett decided to take a major stake in Goldman Sachs (NYSE: GS) on September 23rd, 2008, the S&P 500 (AMEX: SPY) has dropped an additional 30%. That’s bad, but not as bad as the 55% drop seen in the Financial Select Sector SPDRs (NYSEArca: XLF).

Even with Warren Buffett’s long-term investment horizon, a 50% drop is no peanuts.  

Dow 6,500...Why?

As of today, the November 21st, 2008 lows remain intact. Nonetheless the market’s behavior is reminiscent of pre-November 21st moves and indicative of new lows to come. Weeks before the November lows we pointed out via our ETF Profit Strategy Newsletter that the Dow will break below 7,500 (it did) which was to be followed by a rally going into November/December (it did).

On December 12th we wrote: “Optimistic sentiment, which should be more visible above Dow 9,000, gives way to further declines. These should draw the indexes close to or below their November 21st lows of 7,445 for the Dow and 740 for the S&P."

 

On January 6th, we issued a sell signal. Extreme investor sentiment (optimism) was one of the many factors that lead us to call a top on January 6th. Why is this important?

Extreme optimism is followed by equally extreme corrections. Case in point; pervasive optimism also overshadowed the market’s October 2007 highs. We know what happened since.

Another parallel between today and the pre-November lows is the financial sector’s break to new lows. Financials dropped to new lows on November 12th, at that time we wrote: “The Financial Select Sector SPDRs actually closed beneath its October 27th low. This should serve as a nice foundation for the next push down. Once the Dow breaks beneath 7,500, it's time to lighten up on the short ETFs.”

Once again, on January 20th, financials took out their previous (November 21st) lows. Based on the extreme optimism seen on January 6th, the indexes should eventually break well below their previous lows.

The Dow 6,500 ETF portfolio

There are different options to grind out the bear. Highly conservative ETFs simply maintain your purchasing power, others will turn the bear market into profits while some will soften the blow of the bear as they fall and rise with the tide, but to a lesser degree.

How to find safety in a bear market  

A 20% drop in corporate bond ETFs such as the iShares iBoxx $ Investment Grade Bond ETF (NYSEArca: LQD) has driven investors to government Treasuries. Short term Treasuries such as the iShares Barclays Short Treasury Bond ETF (NYSEArca: SHV) maintain a steady price with a low yield. 
 

How to soften the blow of the bear market  

High beta ETFs tend to fall harder and faster than the overall market while low beta ETFs can soften the blow. A beta of 1 indicates volatility equal to the S&P 500. Even though low beta ETFs will rise and fall with the tide, they tend to fall to a lesser degree.  

Such low beta ETFs are often considered defensive sectors. Defensive sectors include consumer staples, health care and utilities. To illustrate; while the S&P ended 2008 down 38.49%, the Consumer Staples Select Sector SPDRs (NYSEArca: XLP) did comparatively well with a 14.98% loss. The Health Care Select Sector SPDRs (NYSEArca: XLV) shed 23.15% while the Utilities Select Sector SPDRs (NYSEArca: XLU) lost 29.09%.

Recent losses emphasized the cushioning effect of dividend yields. Yield hungry investors however are caught between a rock and a hard place. The best performing sectors pay the lowest yields while the highest yields spring from the worst performing sectors. High yields from the financial and real estate sector were more than offset by steep losses.

The SPDR S&P Dividend ETF (NYSEArca: SDY) offers a happy medium. The 23.02% 2008 loss was sweetened by a current dividend yield of 6.45%. Due to its 18.3% allocation to financials, SDY has a beta of 0.65. The iShares Dow Jones Select Dividend’s (NYSEArca: DVY) 27.55% exposure to financials results in a beta of 0.73.

How to profit in a bear market

Past bear markets left some breathing room for one or two pockets of strength. Thus the phrase “there is always a bull market somewhere”. This bear market has suffocated all pockets of strength. The only bull market to be found is in short ETFs and Treasuries.

Starting in the middle of 2007 we recommended short ETFs such as the UltraShort Financial ProShares (NYSEarca: SKF) and UltraShort Real Estate ProShares (NYSEArca: SRS). Above we discussed sectors with the tendency to soften the blow (consumer staples, health care and utilities).

When shorting individual sectors, it is smart to bet on sectors with the propensity to fall harder and faster than the market such as financials, real estate and the UltraShort Consumer Services ProShares (NYSEArca: SCC).

If you don’t feel comfortable shorting individual sectors, you may use broad market short ETFs such as the UltraShort S&P 500 ProShares (NYSEArca: SDS) or UltraShort Dow 30 ProShares (NYSEArca: DXD).