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August 28, 2018

Are You Ready For The Next Crash?

Last week the S&P 500 index reached a new all-time high, and the current bull market became the longest-running ever. But it is important to remember that the previous record bull market of 1990–2000 ended with an 80% crash in the tech-heavy Nasdaq.  The “dot.com” bust was ugly and it left a generation of investors traumatized.

Do we face a similar day of reckoning? Warning signs are creeping into the market. 

The Red Flags

Investors are becoming increasingly skittish about dangers such as trade war and political instability. The S&P 500’s trailing price-to-earnings (P/E) ratio has reached 24.75, a level that it has rarely reached and well above its long-term average of 15.7.  

Investors are also eyeing the narrowing gap between U.S. Treasury two- and ten-year yield
s. This yield curve recently narrowed to its tightest spread since August 2007. A narrowing spread points to investors’ fears over the economy. When this spread turns negative, it’s an historically reliable predictor of an imminent recession.

Are you prepared for a recession?

Not many of us are prepared for a recession and the market downturn that ensues. We are driven by greed and often only become fearful when the danger is obvious. We want to ride this bull market until it’s clear it is no longer a bull market. But no one fires a warning shot, telling you that a market crash is about to happen.

Review Your Objectives

Given the market’s excessively exuberant sentiment, now is a good time to review your investment plans. This starts with understanding the kind of investor you are and your time horizon. Those factors change over time, so periodically reflecting on your investment objectives is a good idea. 

If you are an investor with a decade or more of investment horizon, and assuming you won’t have a need for the money in that time frame, you can afford to be aggressive. You don’t need to worry too much about a correction or recession. Just stick with the course and ride out the inevitable economic slowdowns. Unless your investment time horizon is extremely short, this will be the most profitable course over time, if you can cope with the volatility. 

If you are approaching retirement, or otherwise will need to cash in some of your investments within a few years, you should think about getting more conservative with your portfolio. Better to park money in lower-yielding, but safe investments than risk being down 30% just when you need your money. And trust me, you can be down 30% very quickly if you are aggressively invested. 

Most of us are somewhere in between that extremely aggressive and extremely conservative time horizon. Even for those with a short time horizon, you may still want to have some portion of your portfolio that you devote to riskier investments. 

Coping with Volatility

The equation is easy to understand: higher risk equals higher reward equals higher volatility.
Nobody ever likes to lose money, but it’s inevitable. It’s important up front to consider how much money you would be willing to lose before you would cut losses on an investment. That should be dictated by your own personal discomfort over seeing gains evaporate, but also by your time frame. 
When I talk about different investment options, I try to highlight risk. Consequently, I may discuss a stock that’s appropriate for “aggressive investors.” That is code for an investor that can tolerate a fast and steep decline in investments. Never lose sight of the fact that higher risk will sometimes materialize in higher losses.
Keep in mind that the recession that began in 2008 took the S&P 500 down by 37%. Defensive sectors weren’t spared. The S&P 500 Utility Index fell by 29% that year, its worst ever annual decline. Some of my own holdings took three to four years to recover from the 2008 recession. 
If you can’t afford to wait a few years to recover from a possible decline, you should take defensive measures with your portfolio. Pare back your exposure to pricey momentum stocks; emphasize value. Increase your allocation to hedges. Think about your risk tolerance before you are forced to make an emotional decision in a market meltdown.
Courtesy of Robert Rapier, Investing Daily (More from Investing Daily Here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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