Ever since the market started recovering from the crash of 2008/2009, theres been a lot of talk that the markets going to crash again. The voices were faint to begin with but now theyre growing louder. The theory is that the problems that caused the financial crisis to begin with (excessive leverage and inefficient regulation) have not been resolved. If anything, some argue the factors that caused the crisis have become more widespread.
So, is the market going to crash?
Well, yes, unfortunately it will. Thats actually not news. Its simply the nature of the market and a by-product of human beings being in charge of the market! The real question is, when?
What I want to do now is outline some basic principles that you can follow so that a market crash goes from being a painful and traumatic financial event to something that just happens and will only cause you a minimal amount of inconvenience. I want to take a brief look at some of the classic warnings signs that a crash is imminent.
Us Fools dont just crunch the numbers for the sake it as fun as it is! Were also looking for some red lights or alarm bells. Those can include inflated P/Es, loads of debt in the market or a seemingly endless line of company IPOs. There are just a handle of possible signs.
It can be emotional
Were also looking for the right mood. That might sound like a bit of a fluffy thing to say but its actually very important. Thats because markets are psychological in nature and are run by human beings. Its fairly common for a crash to occur right after a period of euphoria. In fact, talk of a near-term crash in the media will generally start to subside in the months or years before a crash. There almost needs to be a collective delusion that prices can only go up. Its during those periods that every man and his dog is in the share market. Theres an old saying that when your cab driver starts to give you stock market advice, its time to get out of the market (and thats nothing against cab drivers!).
There are also other signs. For instance, the Shanghai Composite dived around 5-6 around the middle of 2007. That was just one of the many warning signs that global markets were in trouble. The Chinese authorities had recognised a potential asset bubble and were trying to squash it. Investors should be on the look-out for similar endogenous shocks on the horizon. It aint normal for any major market to slide like that without there being something seriously askew.
What about practical ways investors can prepare themselves for a crash?
Well, one way is to hang on to a few of the safer defensive stocks like GlaxoSmithKline or Tesco. Thats because folks wont altogether stop going to the grocery market or getting sick during a downturn. No stocks are without risk, but these two stocks arent too bad.
Its also a smart idea to be overweight liquid stocks. That means avoiding illiquid stocks, too. Youre looking for stocks where there are plenty of buyers and sellers at all prices. If a stock is liquid, it means that if you try to sell it in a hurry, theres less chance the price will tumble too far before all your shares have been taken up by buyers on the other side of the spread.
Another great strategy that professional traders employ is the stop loss order. Thats when you set a price at which you will be automatically sold out of a stock. Its not foolproof because if the market doesnt crash then youre left taking a small loss. However, if the market does turn down sharply, youve saved yourself a lot of money.
Stay one step ahead
Please also be on the look-out for more qualitative signs within a company like sudden management resignations or health scares. Executives who are under an enormous amount of pressure (too much stress) tend to get sick.
I personally dontyou shouldnt increase the size of your portfolio while the market is drastically falling. Just hang back a bit. Wait for a dead-cat-bounce to come and go, or for a second big fall. Markets are a bit like people, they often go into denial after the initial trauma.
As always, stay calm and think logically.
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David Taylor has no position in any shares mentioned. The Motley Fool UK has recommended GlaxoSmithKline. The Motley Fool UK owns shares of Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.