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Article by: Sy Harding - 06-03-2008

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It's pretty much agreed now that the economy is probably slowing into recession, and may already be there. It's also becoming more and more feared that the stock market may have topped out and be in the early stages of its next bear market.

If so, what's an investor to do?

The most common advice is to do nothing. As long as you invest for the long-term and won't need the money for five or ten years, such advice says the value of your investments will 'come back' in the next bull market.

That may be true. After the devastating 2000-2002 bear market, in which the S&P 500 lost 50% of its value, it took seven years, but the S&P did rise back up (last year) to a level last seen in 2000. It may take awhile longer for the Nasdaq to come back. In those same seven years it regained only half of its bear market losses. While waiting for the market to 'come back' of course that is 'dead money' that could be making profits elsewhere.

The second most common piece of advice is to move to 'defensive' stocks and sectors, which might not suffer as large losses as the overall market. But, as I frequently prove on my free daily financial blog ,few if any of the areas Wall Street touts as being defensive actually provide any safety at all in serious market declines.

And is it really wise anyway, to choose an investment you expect to go down - because it probably won't go down as much?

There are other choices.

For instance, what could be simpler than cash? When the stock market is in bull market mode, cash is not considered an investment, and for good reason. But when you believe stocks and mutual funds may decline 15% to 40% over a period of time, you might look back and think that a risk-free 5% annual return on cash for awhile was a quite wise investment indeed.

In past eras investors had few other choices, unless they were sophisticated enough to be proficient at selling stocks short. But that is no longer true.

Several mutual fund families now offer 'bear-type' mutual funds, designed to make profits when the stock market declines. They sure worked well in the 2000-2002 bear market. For instance, the Rydex Inverse S&P 500 Fund (www.Rydexfunds.com), designed to move opposite to the S&P 500, gained more than 100% from the bull market top in early 2000, to the bear market bottom in 2002, while the S&P 500 was losing 50% of its value. The Rydex Inverse Nasdaq-100 Fund, which is designed to move opposite to the Nasdaq 100 Index, soared more than 160% during that bear market.

Similar 'bear-type' or 'inverse funds' are available from Profunds Inc. (www.Profunds.com), and direxion Inc. (www.direxion.com).

A portion of a portfolio in those kinds of holdings could be valuable insurance in a bear market, or even a serious market correction.

Somewhat different is the Prudent Bear Fund (www.prudentbearfund.com), a managed fund in which its managers go after downside gains by selecting a variety of stocks and sectors to sell short, while holding some positions on the long-side they expect to go up in a market decline. This fund also produced excellent gains in the 2000-2002 bear market.

Then there are the exchange-traded-funds (etfs).

As you are probably aware, etfs are similar to mutual funds, but like stocks, are bought and sold through any brokerage firm, and at any time during the trading day. Introduced just a few years ago, there are now more than 800 available. Most are designed to track with a specific market index or sector. But there are several dozen that are 'inverse' etfs, designed to move opposite to specific indexes or sectors.

Some of the more popular include Proshares Short S&P 500, symbol SH; Proshares Short QQQQ (Nasdaq 100), symbol PSQ; and Proshares Short Dow 30, symbol DOG. The possibilities in both directions are almost endless. Bullish on the U.S. Dollar? There's the Powershares DB U.S. Dollar Bullish Fund, symbol UUP. Bearish on the dollar? You can take a position in the Powershares DB Dollar Bearish Fund, symbol UDN.

Want to be more aggressive? There are now numerous etfs leveraged to produce double the movement of the underlying index or sector.

So the weapons are easily available to do battle with a bear. But it's important to make sure you're aiming at a bear before you pull the trigger.