Stock Market Crash – How to prepare for the next bear market to minimize the impact on your portfolio

How you can protect your portfolio from a stock market crash and the next bear market

One of the realities of investing is that bear markets occur, and a stock market crash is bound to happen every few years. While a bull market can last for years, as the current one has, it won’t last forever. Investors should always be ready for the next market crash because it could occur in the next few days, weeks, or in a few years’ time.

Stock Market Crash / Bear Market
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In this post we take a deep dive into market crashes, what causes them, and where to put your money before the market crashes. We are not making a stock market crash prediction or forecasting the next bear market, but rather outlining strategies to make sure you don’t get wiped out if one does occur.

What is a stock market crash?

Stock Market Crash
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Technically, a bear market occurs when stock prices decline by 20% or more. A market crash occurs when stock prices fall suddenly. The magnitude of a price decline during a crash really depends on the time frame. If prices unexpectedly fell by more than 3% on a given day, that might be classified as a mini crash. If prices were to fall by more than 10% in a week, or by 20% in a month, that would be classified as a substantial crash.

A stock market crash occurs when supply suddenly increases and demand disappears. Market crashes are generally associated with panic selling and increasing levels of fear.

Bear markets can occur over longer periods. During a bear market there will often be sharp rallies, but prices don’t manage to break out of the overall downtrend. Sometimes during a bear market prices will move sideways in a wide trading range with increased volatility, though the overall decline may be fairly minor. Every stock market crash and bear market is different, which makes managing a portfolio difficult.

How much do stocks decline during a market crash?

Bear Market / Stock Market Decline
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Technically, bear markets see stocks decline by at least 20%. But stock prices can decline by far more than that, and bear markets can also last for a long time. The severity of a bear market has as much to do with the duration as the magnitude. A drawn-out bear market can have a destructive effect on the economy as low investor confidence impacts economic activity.

The stock market crash 1929 was possibly the worst in stock market history. The crash really began in August, but the 29th October 1929, known as Black Tuesday, was when the Dow Jones Industrial Average had its biggest ever one day decline. This marked the start of the great depression in the United States which lasted until 1939. In total the Dow Jones index fell more than 85% over a three-year period and took almost 30 years to recover to pre-crash levels.

The 1987 stock market crash which occurred on Black Monday on 19th October 1987, was a more severe crash. However, the market recovered within 2 years. At the time the 1987 crash was a big deal with stocks losing as much as 32% in 3 days. But if you look at a long-term chart of the Dow Jones index, that crash looks like a minor correction.

Black Monday Crash 1987
Black Monday Stock Market Crash 1987

In 2008, the US housing market crash led to the GFC (global financial crisis), and the S&P 500 fell more than 55%. In that case it took 6 years for stock prices to regain their previous levels. Although the market fell less in percentage terms than it did in 1929, it was the largest amount of wealth wiped out in the history of the NYSE. Another important crash in bear market history occurred on Japan’s Nikkei 225 index which fell from 38,900 in 1989 to 7,055 in 2009. Nearly 30 years after the peak, the Nikkei index is still more than 38% below it’s all time high.

Nikkei 225 Weekly Chart / Bear Market
Bear markets can last a very long time

These examples are some of the worst crashes of the last century. Most crashes are not as severe. Since 1950 the US equity market has experienced 15 bear markets, with a median decline of 26%.

What are events that can cause a market crash?

All bear markets and market crashes are different, and they all have different causes. It’s usually not possible to pinpoint the exact cause of a crash until after the fact. Bear markets can be caused by factors specific to the stock market, economic factors, or a combination of the two. Within the market itself, excessive leverage and speculation can create an environment with too many forced sellers.

If stocks are overvalued and a selloff begins, there is no reason for investors to step in as buyers until a substantial decline has occurred. Declining or disappointing corporate earnings can also cause investors to look elsewhere for returns. The financial crisis of 2008 was triggered by the bankruptcies of Bear Stearns and Lehman Brothers, though there were numerous other causes. If a large financial institution fails, liquidity in the financial system can dry up causing investors to panic.

Stock Market Crash / Economic Downturn
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A shortage of credit can also trigger a crash. As financial institutions struggle to borrow short term funds, they begin calling in the loans they have made, which creates a knock-on effect throughout the market. This is one of the reasons an inverted yield curve is viewed as a warning sign for a pending recession or bear market. The yield curve inverts when short term borrowing rates spike, indicating a lack of short-term credit and liquidity.

Rising interest rates are generally viewed as negative for stocks. There are several reasons for this; higher rates can be a drag on corporate profits, they lead to deleveraging of balance sheets, which leads to asset sales and they make speculation more expensive. However, just because rates are rising it does not mean a crash will occur. Since inflation leads to higher interest rates, signs of inflation can cause a sell-off or bear market in equities. Investor confidence and consumer confidence can also contribute toward a stock market crash.

Trade War / USA vs. China
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Usually there are several factors that lead to a market crash. The fact that markets may be experiencing a stock bubble doesn’t necessarily mean a stock market crash will occur. But something else may act as a catalyst and the fact that stocks are overvalued may then lead to a major correction or crash. Globalization means that markets and economies are all connected. Anything that happens on Wall Street and in the US financial markets can send shockwaves throughout the global stock market within seconds. The same is true of Europe (Brexit) and China, which could be the catalyst for the next market crash.

The magnitude and duration of a bear market will also depend on a range of factors. Stock prices will fall until new buyers enter the market. This will of course depend on how cheap stocks are, the amount of cash available and investor confidence. The severity of a stock market crash therefore depends on valuations, the cash balances held by large institutions and the capacity of central banks to stimulate an economy and restore confidence.

When will the next stock market sell-off happen?

Scared Trader / Investor
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While famous investors are often credited with predicting various market crashes, in many cases those same investors predicted crashes that didn’t happen. The truth is that market crashes are very difficult to predict. Just because stock prices are too high, it does not imply a market crash is imminent. The CAPE ratio (cyclically adjusted PE) developed by Robert Shiller is a common measure of just how expensive stocks are based on historic trends. For the S&P 500, the CAPE ratio long term average is 16.7, it has a low of 4.78 and reached a high of 44 in 1999. In January 2018 it touched 33, and though the market did eventually fall just less than 20%, it quickly regained its all-time highs.

So, how is the stock market doing today? The ratio was at 30 at the end of April 2018. That means stock prices today are fairly expensive. However, they have been a lot higher in the past. The next bear market is probably going to be caused by something besides equity valuations. The China stock market and economy are of concern, and if the Chinese government is unable to manage its slowing economy, this could have ripple effects through global markets. The US / China trade war could also escalate to a level where global markets are affected. If the UK does end up leaving Europe without a suitable plan in place, that could also trigger a global bear market.

The Federal Reserve has also become very adept at managing investor expectations and pumping liquidity into the system when necessary. But that doesn’t mean they will always be able to prevent a selloff in stocks. Rather than asking “when is the next market crash?” investors should rather ask “will my portfolio be able to withstand the next market crash?” Next we’ll cover how you can prepare for the next stock market crash.

How to prepare for the next bear market?

Bull & Bear Markets
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While we cannot accurately make the next stock market crash prediction there are lots of ways to make sure a portfolio is not wiped out by a stock market collapse. Possibly most important is making sure you do not have all your eggs in one basket. Asset allocation and diversification help ensure that an entire portfolio is not in investments that will be hit hardest during a market crash.

While diversifying a portfolio with a range of asset classes like bonds, cash, commodities and real estate will help to mitigate the effects of a stock market meltdown, you can also actively allocate capital to specific defensive and uncorrelated investments. Among these are:

Defensive stocks, including consumer staples, healthcare stocks, and utilities perform better than other stocks during bear markets and recessions. These companies are less dependent on the business cycle, and their profits are less volatile. As investors switch to these stocks their prices can sometimes rise while other stock prices fall.

Fine Gold Bullion
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Safe haven assets are those viewed as the best store of wealth by investors. These assets include gold, silver, US Treasuries, US Dollar and Swiss Francs. When investors become risk averse, capital tends to flow to safe haven assets causing their prices to rise. This makes them a great portfolio hedge. While cryptocurrencies may potentially become safe haven assets, their recent price history suggests they are still viewed as risky.

Market neutral hedge funds or Big Data and A.I. driven funds like the Data Intelligence Fund have a low correlation with the overall market and can generate returns during bull and bear markets. Including these types of funds in a well-diversified portfolio is an excellent way to further reduce volatility over the long term and protect capital during a stock market crash. Long / short hedge funds that use leverage can generate significant returns during a bear market but do come with more risk.

Investors should also consider the stocks held within a traditional stock portfolio. High quality stocks of profitable companies will usually hold up a lot better than small cap stocks, speculative stocks or expensive growth stocks. Cash is king, and companies with strong cashflows and low debt will survive a bear market a lot better than leveraged companies with low margins.

Diversification / Economy
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Investors should also avoid the concentration risk that comes with a portfolio of highly correlated stocks, or stocks exposed to a single theme in the market. This can be done by spreading a portfolio across sectors, countries and regions. Spreading capital across growth, value and income stocks is also an effective way to diversify risk.

To survive a bear market, you need to preserve both your monetary capital and your psychological or emotional capital. That means you should never be in a position where an end to the current bull market causes you so much anxiety that you make irrational decisions. Consider the worst-case scenario and then adjust your exposure to the market to the point where you will be able to take that loss in your stride.

Remember too that bear markets create the best buying opportunities, but you will need capital to take advantage of those opportunities. Holding a higher cash balance will mean lower returns during a bull market but will give you the chance to buy high quality stocks at bargain prices if or when the market crashes.

Conclusion: Prepare your portfolio for the next bear market

So, when will the stock market crash? We don’t know. But we do know it will crash at some point. We also know that in an extreme case, a market crash could erase nearly 90% from the value of stocks. The current stock market is fairly expensive, but the catalyst for the next bear market may well be something other than valuations. If there isn’t a larger correction in the near future, the risk of a market bubble and a more severe crash will rise.

Ultimately investors are rewarded for taking risk. But taking risk involves losing money from time to time. The important thing is to make sure your portfolio will not be wiped out during a bear market, and that a crash won’t cause you anxiety and lead to irrational decision making. You should therefore ensure your portfolio is diversified with a mix of different types of stocks, cash, bonds and alternative assets like hedge funds.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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