How to React to a Stock Market Crash

The Hibernating Bear Awakens

As of the writing of this article, the market has plummeted 18% from its top and is only 2% from a bear market recession (defined as more than 20% decline in stock prices.) Will we get there and what should I do about my portfolio?

Towards the end of the summer, I remember listening to the market forecast. It was very optimistic, and rightfully so, being 9ish years into a bull run (positive stock market returns.) The fundamentals all looked strong with low unemployment, strong GDP, and high consumer confidence. I didn’t see signs of weakness in the market and everyone was touting the unbelievable gains (including myself) that they were yielding in the stock market. Yet that is when I stopped buying.

Why I Stopped Buying Stocks – Before the Crash

I was listening to the market news on my headphones while mowing my law. The news said that the volatility index was at historic lows. I believe the masses took this to mean that the future of the stock market was very optimistic, and they should keep buying. If I have learned anything from Mr. Buffet, it is to challenge the conclusions of the masses when they seem obvious and abundant. The market has its own rhythm and cycles. I took note that Mr. Buffet was keeping the largest cash position that he ever had, on the sidelines, in his company Berkshire Hathaway. I took the news of historic lows in the volatility index to mean that there was a historically easy play on volatility. While I didn’t see any weakness in the market then, I always plan for the season ahead, rather than react to the season we are in. Looking back, that preparation really paid off.

“I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”

-Warren Buffet

Stop Losses – How to Lock in Your Gains

I also tightened up my stop losses (an automated sell triggered when the price falls by the percent you preset to protect yourself from massive losses.) The Shiller PE ratio (an index of how expensive stock prices are relative to their earnings. In other words, how expensive stocks are) was skyrocketing and I wanted to lock in those gains. PE had only been that high in 1929 (Black Tuesday) and during the .com bubble of ’99. The price of stocks was teetering on the second most pricey time in history. I knew that for everything there is a season and the season of above average returns would not last forever.

After the Shiller PE exceeded that of Black Tuesday, I feel fully justified in saying stock prices have been incredibly overpriced for some time. To be honest, I am surprised it has taken this long for there to be any substantial correction (>10% drop) in market valuations. For perspective, the Shiller PE on Black Tuesday was just over 30 while the historical average Shiller PE is around 15. It is very reasonable to assume it will mean revert to a more sane price.

Statistically, the average bull market lasts for 5-7 years, followed by a 1-3 year bear market [based on recent data.] We recently experienced a 10-year bull run. That is an abnormally long run. I know it felt good to relish in the awesome gains year-after-year but by comparison to historical data, a good thing cannot last forever.

Should I Get Out of the Market Before I Lose More?

Arguably the Shiller PE ratio average is drifting to a higher average over time as investing become easier, more affordable, and more accessible thanks to the internet. As of the writing of this article, the Shiller PE is around 26, that is still significantly above the long-term average of 15.  Thus, we could see the prices correcting even further. I can hear you thinking…. “OK, good, he just said sell. That is all the confirmation I need. I don’t want to lose any more money.”

What you want to do and what you should do are two different things. Remember you don’t lose any money unless you sell and actualize losses. And consider that there is a tax implication to selling outside of tax-advantaged accounts. While I have already confessed I stopped out of (sold) many “higher risk” (positions subject to large losses in a bear market) positions, I am still in the market with the majority of my holdings. I am riding the rollercoaster of volatility along with you. Should you sell now?

There are a few stages of life one goes through so the answer is different for you.

Three Stages of Life for Investors

Stage 1: Get out of debt and learning stage (tradition says 35 years >> Mr. Refined says 0-20 years)
Stage 2: Accumulate wealth or wealth building stage (tradition says 30 years >> Mr. Refined says 10 years)
Stage 3: Draw down or wealth preservation for living expenses. (tradition says 10 years >> Mr. Refined says 60+ years)

If you are in stage one, keep paying down that debt get out as fast as possible and hope you do so before the market bounces back up. If you are in stage two, your goal over the next 1-15 years, depending on savings rate, should be a net accumulation of investable assets. If you choose to sell, you only do so with the strong expectation that future prices will be lower and you will be able to buy more [shares] then. If you are in stage three, the drawdown stage of life (note: you can avoid drawing down for many decades after you retire if your business(es) and properties are cash flowing but that is an article for another time.) you do nothing! Yes, I will repeat that…if you are drawing down, you do nothing! Keep on living your life as you planned. Your retirement plan was built for many storms greater than this one. Remember the 4% Rule built in the following probabilities of market drawbacks, corrections, and even recessions.

You see, the market corrects all the time. If you are not comfortable with that probability of volatility you may want to tie Ulysses to the mast and consider entrusting a financial advisor with your assets. Stay the course, unless this market correction evolves into a prolonged recession or several corrections occur in rapid succession, you’re fine. If that eventually does come to pass, and you are near the beginning of your retirement, you may wish to reengage with a side hustle to recuperate the sequence of returns loss by adding additional cash supply to the portfolio. However, we have years to go before we need to worry about that eventuality. Since we are nowhere near that combination of unfortunate events, do yourself a favor, stop checking the portfolio and go enjoy the weather and health that you have today.

“Equities will do well over time — you just have to avoid getting excited when other people are getting excited.”

-Warren Buffet

So Sell? Hold? Buy?

Your situation depends on more factors than I know so let me tell you what I am doing. Be mindful that I am in the accumulation stage of life with ~9 years to my FIRE date (hopefully not the only date I get in the next 9 years.) For the remaining positions I have, which have not yet sold, I am trusting the analysis that went into my stop loss calculations. Each calculation is based on the individual volatility quotient. If the individual holding drops to that calculated stop loss price, I expect it will continue to plummet in price and therefore will be why it sells at the calculated price to lock in my gains. (note: this is a level two strategy not suitable for level one investors.)

I am flexing my steely nerves that my math is just as valid today in a falling market, as it was in a rapidly expanding market when I calculated those stop losses. To be perfectly transparent, I am really struggling with this now. I feel like I am watching the fuse on a bomb slowly burn down to the rough metal ball. I am fighting the temptation to sell, as I expect markets will continue to plummet. Fortunately, I have an investment plan statement in my trade log that I read to bring me comfort and stay the course. Lately, I have incorporated reading it into my nightly prayers.

What I don’t know, is how much further the market will drop. What I do know from my personal trade log, is that my performance is strongly correlated to the market analysis, math, and projections I do before I buy. The positions that I enter on a feeling or on a tip from crazy uncle Al, are my biggest losers. The positions I have done the best in, are those that I do the most analysis on and wait patiently until the share price reaches my buy price. So, I have to tie my hands to the mast here and now, and trust in that I do know, rather than worry about what I don’t know.

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

-Warren Buffet

Algorithms, Artificial Intelligence (AI), and Trade Bots

It is no secret that technology is in control of trades these days. Less than 10% of the market is traded traditionally by humans based on fundamentals according to JP Morgan representatives. This is one of the largest influences we need to be mindful of. Big money uses algorithms. The last recession was in 2008 and a much smaller fraction of the market was traded automatically and even then the computer output was double-checked by a humanoid. The current volatility is the first true test modern AI and algorithms will have. The velocity of price movement will increase because of the nature and speed of electronic trading and modern AI. In other words, more AI = much more market volatility.

As we learned from the flash crash years ago, algorithms can drive the market so fast, the regulatory commission had to implement new regulations to slow down the market velocity. There is more computing power on Wall Street than there is the rest of the world combined. These algorithms attempt to siphon a penny off millions of quick trades. When done millions of times with billions of dollars, pennies begin to pile up. Wall Street uses their supercomputers to “cut in line” and put their orders in ahead of our orders, taking advantage of the slight price change caused by each order.

We, individual investors and traders, typically do not trade on algorithms with our comparative chump change.  This is not our weakness but rather our advantage when used responsibly. We don’t need to focus on the up and down of every wave in the ocean. We just need to check and adjust our bearing from time-to-time in our long and slow voyage to retirement.

Can Politics Influence Volatility?

Let’s look a little deeper than trade negotiation. Personally, I am being patient. I could foresee extreme volatility continuing. I could even see it continuing for a protracted period of time. I might even be inclined to believe it will continue for almost exactly as long as the current administration holds office. I can’t recall a time period where the Fed. was destroying monetary supply to the tune of $50 billion a month and hiking the interest rate a quarter point every quarter at the same time. It is an interesting combination. The effect would simultaneously suppress the bond market (which is inversely proportional to the interest rate) and the stock market. They probably just made a silly little “oopsie” and didn’t realize that they happened to be doing both at the same time. I am certainly not saying the Fed. has any incentive to artificially suppress the economy for some kind of political reason, no, no, no. Those actions would certainly make the current political administration look bad. I am sure that those with the ability to control monetary supply (aka have unlimited resources) only act in the best interest of the greater public and economy and have no interest in politics whatsoever. I mean sure other governments have corruption but that could never happen in our government, could it?

It is likely also a coincidence that the Fed. did the exact opposite actions during the previous administration. Although they consistently dropped the interest rate to nearly zero and at the same time printed money to a tune of $85 Billion dollars a month flooding the market with free cash supply. These facts are likely coincidences and I trust were not in any way intended to make the previous administration look good, say in a protracted bull run. It is too conspiracy theory-ish for me to believe that the organization responsible for monetary supply would have political interests and use the unlimited resources at their fingertips to try to influence politics. That kind of thing could only happen in the movies, not real life, right?

On a completely unrelated note, time for randomly selected quotes from guys who probably don’t know jack.

“Understanding reality is imagining life without coincidence.”

– Albert Einstein.

“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”

– Warren Buffet

When to Buy?

Most of the readers of this article do not have the resources to influence politics. Now that we are convinced that manipulating monetary supply and therefore the performance of the bond and stock market would never be done for political reasons, we can move on to factors that could influence the market. So, what can we take action on? We have talked about selling and holding so is now the time to buy?

Look at the Underlying Fundamentals

GDP was an astounding 4% this last year. The IMF (global central bank) is forecasting a 3.7% GDP for ‘Merica next year. Consumer spending confidence is at a 6 year high. The unemployment rate is at, in my opinion, the most optimal possible value of 4%. Low is good, but any lower than 4% and you start employing people less employable than say, J-Money. 😜  I love you J Money. While a PE of 26 is very high, with numbers like those just mentioned it does not take long for prosperity to grow into that PE. In other words, stocks will earn that price relatively quickly if productivity continues at these levels. So, in non-brain busting terms, the economy is actually crushing it right now. And if Mr. Economy was sitting next to me I would raise a glass and cheers him. So, if the Fed. stopped oppressing the market it would be a happy little dude and maybe buy us the next round of beers.

“Four or five times during their lifetimes, [investors will] see incredible opportunities probably in equity markets . . . [they] have to have the mental fortitude to jump in when most are jumping out.”

– Warren Buffet

If you have steely nerves like me, wait for the market to curl up and start to show positive expectancy indicated by midterm futures. If you don’t have nerves of steel, begin to slowly dollar cost average in at steeply discounted prices. If you are in the retirement stage of life, begin to slowly transition bonds to equities at these discounted prices. If you are a Jedi Master financial guru type, simply stick to your written personal financial plan statement. Be true to your colors because the colors of the American flag look bright under my continued solute to the US economy.

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

  – Warren Buffet

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Disclaimers:
*These views are subject to change in the next 10 seconds. The cool thing about being a blogger is that as the economic conditions change, so can my views change.

**I said I stopped buying investment positions but for readers that know me, I am not that much of an absolutist. I cooled off on buying. I was still rebalancing and bolstering positions, but this was less than 2% of my portfolio. For an accumulator like me, that is categorized as stopping.

***This site is for informational and entertainment purposes only and shall not be construed as investment or tax recommendations or advice. Because of the nature of the interactive dialogue inherent in the format of this site, it is important for readers to understand that not all comments made will apply to them specifically. Nothing said shall be taken to be investment or tax advice, nor shall statements on this site be considered an offer to buy or sell securities. Such advice is rendered solely on an individual basis and at times will require that the investor review a  prospectus. You should seek advice for your specific situation from a certificated financial advisor and a certificated tax advisor. On most days I don’t claim to be an expert or even an adult.