Hello again, Sleuths,

If you have been a devoted reader of my Technical Tuesday columns in Penny Sleuth, you know that my outlook for stocks in 2006 is — to put it mildly — bearish. If 2006 turns out to be a down year for equities, it will be more of a challenge to extract money from the market.

So the question becomes: how do you actually make money in a rocky market environment? One way is to subscribe to one or more of our newsletters we publish here at Agora Financial. We’ve got a diverse team of accomplished financial editors who regularly uncover special situations that can make you money in any market climate.

Another way to pull out profits from a struggling market is to find the sector or sectors that are able to buck the trend. In fact, you may recall that I devoted two columns last December to point out the profit potential just waiting to be plucked in the gold and precious metals markets. Boy, did that turn out to be an understatement!

Downside of the Market: Looking for Golden Opportunities… Besides Gold

I hope you took advantage of that information to pad your trading or investment account. Needless to say, gold stocks exceeded my expectations and put a ton of money in the pockets of astute traders and investors in a hurry. Or maybe a more accurate way to put it is that the gold sector reached the 2006 goals I laid out for it in a little over a month.

Gold has pulled back quite a bit from its lofty heights of two weeks ago. But I think there are still more profits to be had in this shiny corner of the market. So, Sleuthers, I suggest you continue to keep an eye on it.

But there is another way to make money in a down market. Remember the old saying, “The trend is your friend”? While it’s gratifying — and profitable — to buck the trend by ferreting out the few sectors able to soar in a down market, it’s actually easier to put your money in a sector that’s traveling in tandem with most other equities. And if I’m right about 2006, that trend will be pointing south.

What I’m getting at is that there is still another way to score gains while the market is taking a header. Why not take a walk on the short side and trade or invest in areas of the market where prospects appear poor and where equities are likely to suffer alongside the market averages?

Doesn’t it make sense — if the market proves to be as weak as I think it may be — to locate an anemic corner of the investment world and implement a trading or investing strategy that seeks to profit from continued weakness in that sector? It’s not as conventional an approach for most people as buying stocks. But it can be just as lucrative.

How can you attempt to profit from trading or investing on the short side of the market? There are several ways you can do it.

Downside of the Market: Short Funds

First, you don’t even need to look at specific market sectors. You can simply invest your money on the overall downside of the market. There are a number of ways to do this.

You can short an exchange-traded fund (ETF) that acts as a proxy for a broad or well-known market index. There are several of these ETFs that have been created to mimic the return of different broad-based market indexes. Three of the better-known market-based ETFs are the SPDRs (SPY:AMEX), which tracks the S&P 500; the Nasdaq 100 Trust Shares (QQQQ:NASDAQ), which follows the Nasdaq 100; and the DIAMONDS Trust, Series 1 (DIA:AMEX), which mirrors the return of the Dow Jones Industrials. But there are others as well.

If you are not comfortable — or are unfamiliar — with the concept of shorting, you can buy put options on a major index or broad-based ETF. There are two advantages of purchasing a put option. First, unlike shorting a security, your risk of loss when purchasing an option is limited to the amount of your investment. Second, you have the opportunity to earn outsized profits from relatively modest market moves through the concept of leverage.

But options aren’t for everyone. So there is another way you can capitalize on negative market moves. And it’s more conservative — and simpler — than either of the two alternatives I just mentioned. You can invest in a mutual fund.

Now, what’s different about this type of mutual fund from others you may have purchased is that it seeks to profit by a decline in the market. There are a number of mutual fund companies that offer funds that are inversely correlated to a specific market index. In other words, if you think a particular market average is going to decline, you can invest in a mutual fund that is inversely correlated to that index. If your assessment is correct and the index drops, your mutual fund should correspondingly increase in value.

Some mutual fund companies even offer funds that are leveraged so you can reap magnified rewards from market moves in your favor. For example, certain funds enable you to earn 1.5% or 2% for every percentage point decline in the market index you have a bearish outlook on. Just keep in mind that if you invest in one of these leveraged market-indexed mutual funds, not only is your potential for gains heightened, but so is your risk of loss.

Now, if you want to really get in gear with the market trend and attempt to profit from a correct negative market forecast — and stack the odds of success more firmly in your favor — you could bet on the downside of a particular sector or industry. I find this approach to be a particularly attractive one. I say that because it’s my philosophy that the best way to make money in equities is to buy the strong stocks and short the weak ones.

Downside of the Market: ETFs

The approaches you could employ to exploit the perceived weakness of a certain market sector are similar to those I just described for capitalizing on a general market move south — with the exception of investing in bearish mutual funds. There are a host of ETFs tailored to specific market sectors that you could elect to short. You can also buy puts on several of those ETFs. Or you can target a handful of stocks within a market sector to either short or to buy puts on.

Whichever approach you choose, you will likely be rewarded if your bearish assessment of a particular sector proves to be accurate. And if you act on that forecast while overall market conditions are also poor — you will have further increased your chances of success.

So what sector looks ripe for a fall if the overall market should take a powder in 2006? Ah, dear Sleuths, for the answer to that question you will have to read my next column in two weeks. At that time, I’ll take the technical temperature of one corner of the equities world whose prospects over the next several months appear dim. Until then, if the market seas do turn rough and you are wondering how to turn a profit — you may want to consider taking a walk on the short side.

Trade well,

Mark Bail
February 14, 2006

Downside of the Market: Take a Walk on the Short Side was originally featured in the Penny Sleuth.