When the stock market crashes, it gives warning signs. Red flags start to go up as much as six months in advance. Furthermore, market crashes usually take around a year-and-a-half to complete, from top-to-bottom, so it’s not as if the market falls 40-50% in value overnight. Naturally, everyone wants to avoid these terrible, yet inevitable events. The good news is, it’s possible to avoid a portion of the negative returns. You just have to know what to look for, and of course, you have to be paying attention.

Never look at a chart and assume that, because you made 100%, but “only” lost 50% in the past, that your portfolio is still in the black.  Here’s the math:

  • $1,000,000 doubles (+100% gain) to $2,000,000
  • $2,000,000 loses -50% of its value = $1,000,000

Heaven forbid you’re taking withdrawals from your portfolio to supplement your income.  If so, your portfolio will have dropped to number lower than your starting point.

Here are the rules that any savvy investor should follow to stay invested during the good times and avoid the crashes.

Rule #1:  There’s no way to get out at the very top – that would require predictive power, which no one has.  You’d be guessing and leaving your money to chance doesn’t usually work out so well in the end.  So, throw this out of your mind right away.

Rule #2:  There’s no way to get out right at the very bottom (again, this requires clairvoyance and more shooting in the dark).  Same thing here, toss this brain trash where it belongs.

Rule #3:  Have a well-thought-out strategy and system for getting out and getting back into the market.  Ideally, the variables in the strategy should have been tested over up markets, down markets, and in flat/neutral/trendless markets.

Rule #4:  Review, re-test, and adjust your rules-based strategy at least once per year to ensure it still produces the kind of results you desire… especially if the prior years’ results weren’t satisfactory.

Rule #5:  Relentlessly and religiously follow the rules without “liking” one investment over another, and without hope, excitement, anger, anxiety, or any other emotion for that matter.  An investment strategy should be emotion-less.

What about #3?  What should these variables include? 

There are many different time-frames.  Some investors are super short-term, some look out 2-3 weeks, some use an intermediate-term time-frame and others look at the ultra long-term and don’t typically plan to avoid crashes at all.

I would be in the intermediate-term camp.  My typical holding period is six-to-nine months, although there are plenty of times when we’ll hold an investment longer than a year, but only if it looks healthy and its trend is intact.

In terms of variables, I tend to use a combination of long-term moving averages (i.e. – trends), market breadth indicators, and momentum studies all combined together to create a “weight of the evidence” approach to determining whether the market is healthy or not.  However, as the saying goes, “There are many ways to skin a cat.”

I’ve tested the buy and sell-side strategies that I use in our clients’ portfolios and feel comfortable with the moderate time frame we use.  Although, there have been times when clients have interviewed us and we’ve determined there isn’t a fit – either because their time frame is too short (they want quick and/or unrealistic portfolio gains with little-to-no risk, and there is no such thing!), or they want to hold onto dividend-paying stocks forever…and that’s not something we do, either.

So, let’s use just a couple pieces of the variables I use to determine how healthy the market is today.  Follow the numbers at the right in the chart below:

  1. This is an overhead ceiling we want to get above and would be a first sign of short-term improvement for the case that this market continues heading northward from here.
  2. This is the January highs, which mark the all-time highs in the stock market right now. If we can get above here for a few days, I think we’re in really great shape going forward.
  3. A drop below this level would be something to pay attention to, but nothing to panic about.
  4. A drop below these May lows would be concerning and would likely represent a potential break-down in the bigger picture.
  5. If we were to see the market fall below this level, which represents the February and April lows, the long-term trend of the stock market is in jeopardy and there is a big reason to start taking drastic defensive measures to protect capital.

These are the levels I’m watching today, and while there are many other indicators I’m watching that are nearing levels of concern, there are also several red flags that just simply have not gone up yet. Understanding that the market is in a long-term uptrend roughly 70% of the time, we want to allow it to be innocent until proven guilty… and again, whether you’re someone who’s been in the market and wished you would’ve gotten out in the past – or more likely today, someone who got out and you’re frustrated that the market continues to rise while you sit on the sidelines, watching – predicting and guessing will only get you into trouble.

Feel free to fire any questions my way. In the meantime, try to stay cool this weekend, enjoy the Independence Day holiday with your friends and families, and we hope to hear from you soon!

Till next time…
Adam