6 Ways to Protect Yourself From Falling Stock Prices

(Image credit: Michael McCloskey 2007)

published 21 March 2017

You don’t need a fear of heights to feel skittish about stocks these days. Recently passing its eight-year anniversary, the bull market has been running for more than 2,900 days, the second-longest stretch in history. Even after the market plunged 1.2% on March 21, share prices of large-company stocks are still up 10% since the presidential election alone. As Goldman Sachs sees it, the U.S. stock market is now more expensive than it has been 90% of the time in its history.

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A pricey market isn’t necessarily cause for alarm. It usually takes a looming recession to terminate a bull market. But there are no signs of an economic slowdown on the horizon. Quite the contrary. Investors are anticipating faster economic growth, spurred by a rollback in government regulations by the Trump administration, expected tax cuts, and a revival of “animal spirits”—rising confidence that propels business and consumer spending. Economist Ed Yardeni predicts that Standard & Poor’s 500-stock index, which closed at 2,344 on March 21, could hit 2,500 by year-end. “The race most likely isn’t over for the latest bull run,” he says.

Nonetheless, some strategists say the market has risen too far, too fast, climbing more on aspirations than real improvement in the economy. Corporate insiders are selling stocks at a breakneck pace—in contrast to everyday investors, who are buying in droves, says economist David Rosenberg, of money management firm Gluskin Sheff. The trend may be signaling excessive exuberance for stocks that isn’t warranted by what company insiders are seeing. For a variety of reasons, Rosenberg says, “we have a market ripe for a near-term correction” (a decline of 10% to 20% from the market’s peak).

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Even if you’re not nervous about the market, rising prices may have pushed your stock holdings well above your target investment mix. If a year ago you built a portfolio that had 65% in stocks and 35% in bonds, market performance has thrown your asset allocation out of whack. With the stock market up 18% over the past year and the U.S. bond market essentially flat, your stock allocation could be above 75% today.Trimming your stock allocation by about 10 percentage points will get you back to your target mix. You could leave the money in cash. Or plow it into bonds, most of which yield more than they did a year ago. Bond funds we like include Metropolitan West Unconstrained Bond (symbol MWCRX, yield 2.3%), DoubleLine Total Return Bond (DLTNX, 3.4%) and Pimco Income Fund (PONDX, 3.5%). The DoubleLine and Pimco funds are members of the Kiplinger 25, the list of our favorite no-load mutual funds

Choose what you sell carefully. Bank stocks may look vulnerable after today's 3.1% average decline in financial stocks overall. But many analysts recommend holding onto bank stocks, which should benefit from steeper interest rates and an improving economy. But shares of utilities, makers of food products and purveyors of household goods look especially rich and tend to be sensitive to swings in interest rates, says Bank of America Merrill Lynch. High-yield stocks such as AT&T (T, $42.07) and Verizon Communications (VZ, $50.14) may also slump in a rising-rate climate, though their dividend yields, now north of 4.5%, provide some downside protection. (Unless otherwise indicated, prices and yields are as of March 21; returns are through March 20.)

Keep tax consequences in mind. If you dump investments you’ve held for less than a year in a taxable account, you could face short-term capital-gains taxes, which sting at a top rate of 43.4% (including a 3.8% Medicare surtax if your adjusted gross income exceeds $200,000). If you sell after you’ve held an investment for more than one year, the top capital-gains tax drops to 15% for most taxpayers.

Investors often sell call options against stocks in their portfolio to protect some of their gains and pocket a little income on the side. You can do it yourself, without much fuss, or invest in a fund that deploys the strategy. Either way, selling calls can create a modest buffer against losses in individual stocks or the market overall, though the strategy won’t help if we have a repeat of the stock market’s 37% collapse in 2008.

To do it yourself, you’ll have to know a few things about options. Calls grant the owner the right to buy a stock at a preset price, called the strike price, up to a certain date in the future. One option contract controls 100 shares of the underlying stock. The cost of the option is called the premium, and it generally tracks the price of the underlying stock. Options can last anywhere from minutes to months before they expire. Calls generally gain value as a stock goes up. If the stock declines, the call will usually follow it lower.

Let’s say you own 100 shares of Southwest Airlines (LUV, $51.88) and decide to sell a call against the stock. You could sell one call contract expiring on September 15 with a strike price of $55 for $2.86 per share. You would immediately earn $286 from the sale (less the brokerage commission). If Southwest’s stock exceeds $55, you will likely have to relinquish your shares to the option’s buyer. But you’ll keep the option premium no matter what. If the stock stays at or below $55 and isn’t “called,” you’ll get to keep your 100 shares, too. And you’ll also collect any dividends that Southwest pays between now and when the option expires or the stock is called.

If all this sounds too complex or unwieldy, consider buying a “covered call” fund. Such funds sell calls against stocks in their portfolio or the overall market, covering the options with underlying shares they own. By their nature, these funds have no shot at keeping up with a rising market. They could also falter because of lousy stock picks. But if the market does take a dive, they should hold up better than funds lacking such protection.

Say you think the S&P 500 will slide by 10% by year-end. You could buy a put option against the SPDR S&P 500 ETF Trust (SPY, $233.73). The $225 put with a June 16 expiration closed at $3.06 (meaning one contract would cost $306). If the market slumps, you could profit handsomely. If the S&P 500 fell to 2,200 by mid-June, a decline of 6.1% from the S&P 500’s March 21 closing price, the option would be worth roughly $6.50 at expiration—a 111% return.

If you’re really convinced that stocks will nose-dive, you can take advantage of it with a bear-market mutual fund or exchange-traded fund. These funds may sell stocks “short,” selling borrowed shares that they hope to replace later at a lower price, thereby profiting if prices fall. The funds may also use options or other strategies to wager against the market. Over long periods, the funds aren’t likely to produce the exact inverse of the market’s performance (because of anomalies in the daily compounding of returns). But they can at least turn some of the market’s declines into profits.

The Pimco StocksPlus Short Fund (PSSDX) uses futures contracts and other investing techniques to try to replicate the opposite of the S&P 500’s daily return. The fund only needs a small amount of assets to implement the strategy and invests the leftover cash in low-risk bonds, which generate income on the side. Those payouts haven’t prevented the fund from racking up steep losses over the past decade, with returns sliding at an annualized rate of 5.4%. The losses aren’t a surprise, though, considering that the S&P 500 has returned an annualized 7.6% over the same span.

One way to hedge against the market, while staying invested, is to move some of your stock investments into a long-short fund. Such funds have the flexibility to bet on stocks or against them. Schwab Hedged Equity (SWHEX), for instance, holds 270 stocks, with about 57% in long positions and the rest in stocks held short. Over the past decade, the fund has captured 61% of the market’s gains and 63% of its losses, according to Morningstar.

If the stock market tumbles, it will drag down all sorts of risky investments. In that scenario, investors will likely flock to the reassuring arms of Uncle Sam. Long-term government bonds have reliably headed in the opposite direction of stocks for many years, says Christine Benz, director of personal finance at Morningstar. Vanguard Long-Term Treasury (VUSTX) illustrates how the relationship works, she says. While the S&P 500 lost 37% in 2008, the fund gained 23%. In subsequent years, when the S&P 500 rallied, the fund posted heavy losses.

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Daren joined Kiplinger in July 2015 after spending more than 20 years in New York City as a business and financial writer. He spent seven years at Time magazine and joined SmartMoney in 2007, where he wrote about investing and contributed car reviews to the magazine. Daren also worked as a writer in the fund industry for Janus Capital and Fidelity Investments and has been licensed as a Series 7 securities representative.