How to Protect Yourself and Prosper in the Coming Bear Market

It's not easy being financially illiterate.

Over three years ago, I began researching and writing about the impossible debt problems faced by several of America's largest and most trusted enterprises: General Motors, Fannie Mae, and Freddie Mac.

The hate mail came into my office by the truckload. I can sum up the sentiment as, "Porter... you're brain dead. You're un-American. You've lost your mind."

I wasn't digging up hidden, insider facts. I simply performed a basic analysis of each of these companies' ability to take in cash, viewed against its ability to pay out cash to its creditors. The only possible future for all three was bankruptcy. As you know, each of these stalwarts went under... while their stooge managers collected enormous salaries, smiled in front of the cameras, and told you everything was fine.

I tell you this story because I'm getting hate mail again... but my prediction of a U.S. government bankruptcy is much more serious... and the ramifications are much larger.

If you haven't read my writings on why I expect a debt crisis to crush the value of the U.S. dollar, I encourage you to do so here and here. It's the most important analysis I've ever done. Simply put, just like GM, the U.S. government has taken on ridiculous debts that it cannot pay back. But then the million-dollar question arises: If Porter is right, what do I do with my money?

Stocks are trading at big multiples to earnings. High-quality names and low-quality names are just too expensive right now to be bought safely. Volatility in the market has almost disappeared: Stocks have gone nowhere but up for nearly a year. Isn't that a sign I must be wrong about all of these financial problems?

Not at all. The huge run-up in equities we've seen over the last year is merely proof our central bank is still powerful. The stock market rebound that's lifted shares in the United States started the same week the Federal Reserve began its $2 trillion program of "quantitative easing" – which simply means printing up money and buying debts with it.

The Fed's program is scheduled to end this month. That's when we'll have our first real test of the true appetite for risk. I bet we see a big correction in the stock market at exactly the same time.

So the first thing to do is stay cautious of the stock market. Stick with stocks that can greatly increase earnings during an inflationary period and/or have a large and safe dividend stream to protect you against a bear market.

Next, one of my favorite trades here is a wager that gold (GLD) continues to outperform U.S. long-dated Treasuries (TLT) – which you can see in the chart below.

Over the last six months, we've seen gold outperform long-dated U.S. Treasuries by roughly 15%. I expect this trend to continue and accelerate over the next six months as the Fed stops supporting the U.S. Treasury market. Stay long gold, and stay long its hard-money cousin, silver.

Third, learn how to short stocks. Learn how to profit as stocks fall. You can find good explanations of short selling in any standard stock market or trading guide. When short selling, focus on companies that are frauds, overly indebted, or obsolete (for the "indebted" and "obsolete" columns, I like newspapers).

What most people don't understand about a period of increasing inflation is that even though growth in the money supply will increase earnings, matching increases to interest rates force equity valuations lower. And in the race between valuations and earnings, valuation almost always wins.

It's hard to make money in stocks (on the long side) if the market's overall earnings multiple falls in half. If stocks go from trading at 20 times earnings to trading at 10 times earnings (which is what I expect will happen), your stocks will have to double their earnings for you to merely break even, outside of what you're paid in dividends. So short sellers will have a tailwind at their backs.

As the great Richard Russell reminds us, "In a bear market, he who loses least, wins." I agree with Russell. It's hard to make money when markets fall. And while I can't guarantee sticking only with the safest stocks, betting on higher interest rates, owning gold and silver, and short selling stocks will make you rich, I can guarantee you'll be much better off than someone who ignores my advice... like the shareholders of GM did in 2008.