How to prepare for a potential bear market

October 2, 2018

Here’s a question I have been getting for the past few years, but it’s happening more often: “Should I make portfolio changes ahead of the coming market crash?”

This is a big concern for most investors now. Anyone with substantial assets in the stock market knows the nearly 9½-year-old bull market is long in the tooth. Rallies don’t last forever, although it’s impossible to identify the time a correction will begin, or the event that may serve as a catalyst.

So let’s address the big question: What should you be doing to protect your capital ahead of the coming downturn?

Let’s begin by looking at the largest domestic stock index, the Standard & Poor’s 500 index of the 500 largest U.S. companies.

Companies within the S&P 500 are weighted according to market capitalization, or the shares outstanding multiplied by the share price. Big companies such as Apple, Amazon, Microsoft, Berkshire Hathaway and Facebook have a bigger impact on index performance than smaller components, such as Under Armour and News Corp.

A close look at performance of the S&P 500 this year shows that leadership of a few top-performing big firms has been driving gains. Year to date, the S&P has advanced more than 9 percent, not including dividends. However, according to New York-based investment researcher INTL FCStone, a handful of big companies, including some of those named above, are the main catalysts of the index’s appreciation this year.

This narrow leadership could be a bearish sign. If a rally does not have breadth, or strong gains among a large number of companies or sectors, it may signal weakness brewing in the broader market.

Markets often race to new highs, and in heavy trading volume, just before peaking and rolling over into a correction. For example, March 2000 turned out to be the height of the dot-com boom. Stocks reached all-time highs, accompanied by higher-than-average buying volume, just before sputtering out and entering correction territory within months.

A similar event occurred in October 2007, just before the financial crisis began.

In mid-September of this year, the S&P 500 climbed to a new high in heavier-than-normal weekly trading volume. Why am I harping on the trading volume, or the level of buying or selling? It’s because this turnover can indicate investor exuberance or pessimism.

At this stage of the bull market, which got underway in March 2009, late arrivals to the party may be pushing stocks higher, hoping to get in on the action. For what it’s worth, big institutional buyers, such as mutual funds, pension funds, banks and insurance companies, tend to buy stocks at lower valuations and remain invested; they don’t have the retail investor’s emotional tendencies to buy and sell based on news, hope or fear. That’s why it’s somewhat unsettling to see heavy buying that pushes stocks to new highs this late in a bull market.

Does that mean the S&P 500 will roll over tomorrow? Not necessarily. But just like death and taxes, a correction is always inevitable after a rally.

There are ways to protect yourself. Panicking and hitting the sell button is not one of them. Keep in mind: The asset class I’ve been discussing here, large-cap U.S. stocks, represents only one category of security. Risk can be mitigated by allocating across different asset classes.

For instance, a portfolio containing stocks of large and small companies based not only in the U.S. but also in overseas developed and emerging markets, can help smooth volatility. Adding assets that tend to move in a noncorrelated fashion with U.S. equities also can help. Believe it or not, publicly traded real estate investment trusts may mitigate volatility, as can short-term, high-quality bonds.

Asset allocation is a term you might hear when it comes to portfolio protection. It simply means investing in the right mix of equities and fixed income.

Bonds are important to hold, to dampen the volatility of stocks, but I would caution against believing bonds offer complete protection against a market decline. As interest rates rise, bond prices generally decline.

In our current environment of rising rates, it’s not necessary to cash out all your fixed-income holdings, but it is imperative that you understand the role of every stock, bond or fund that you own. Sadly, too many investors have no idea why they are holding any particular security, and their portfolio tends to reflect chaos more than any type of predetermined strategy. It doesn’t have to be that way.

Learn more about this topic at a free workshop, “How To Survive The Coming Bear Market,” from 5:30 to 6:30 p.m. Thursday at the Santa Fe Main Library downtown, 145 Washington Ave. To register, call Erika at 844-507-0961, ext. 700, or email WeCanHelp@BetterMoneyDecisions.com.

Kate Stalter is president, senior adviser and market strategist at independent asset-management firm Better Money Decisions. To learn more about the firm’s investment services, contact Stalter at 844-507-0961, ext. 702, or kate@bettermoneydecisions.com.

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