Saturday, July 28, 2012

What To Do For A Market Crash

I received this comment/ question recently:

"Any chance you could write a post about what a person could do if they see a collapse coming.  For instance, what would I do with my 401k if the market started tanking or if I felt like it was about to crash?  What has been the smart thing to do in past recessions?  Those are questions I'm sure a lot of people right now are worried about."

That last statement is probably quite accurate, so I am addressing this question as a post, because I do think it is on a lot of people's minds.

First, it is important to remember that we cannot predict the future.  The market is made up of millions of buyers and sellers and it is impossible to predict the actions of these people.  It is also quite difficult to predict the actions that will be taken by the government and the Federal Reserve.

While a lot of people may be worrying about such a scenario, it doesn't mean it will happen.  The day after this comment was written, the Dow surged past 13,000.  We must not forget that the Fed tripled the monetary base after the fall of 2008.  Some of this may be leaking out now and it could easily cause a boom in asset prices such as stocks.  Again, it is impossible to predict with certainty.

For that reason, I continue to advocate the permanent portfolio as described by Harry Browne in his book Fail-Safe Investing.  It is designed to protect your investments in any economic environment.  While it probably has its poorest performance during recessions, we have to remember that recessions are usually short-lived.  They will turn into depressions or rebounds.  In addition, price inflation tends to be low during recessions, so you are not losing much to inflation.  In an inflationary recession like we saw in the 1970's, then gold will probably do well.

But what if you are a good speculator and you really strongly believe that the market is about to tank?  What can you do with the speculative portion of your investment portfolio?

If you are really brave and you think you can time the market crash, then you should be playing the futures/ options market.  If you buy put options on the stock market, then you are betting on it to go down.  But it would have to hit a certain strike price before the option expires, otherwise it will be worthless.  (You could technically make money if the market goes down and it doesn't reach your strike price, if you sell it early enough before expiration.)

Again, the problem with options is timing.  If your prediction of a market crash is a little early, then it will probably cost you the full premium that you paid for the option.  However, if you are correct, then the leverage can be very powerful and you can make a lot of money in a short period of time.

If you believe a market crash is coming but aren't certain about the timing, then you have a number of choices.  You obviously want to be out of stocks completely.  Bonds will most likely do well if interest rates go down.  I understand that this is a scary investment to some people right now because rates are already so low.

Another choice is to buy ETFs that short the market.  You can even leverage your money and buy double or triple inverse funds.  SDS is twice the inverse of the S&P 500.  DXD is twice the inverse of the Dow.  You can even buy something like SPXU that is three times the inverse of the S&P 500.  These funds will all go up in a down market.

One warning I have about these funds is that they have management/ expense fees and they also don't always correlate perfectly with the index in question.  For that reason, I would try to avoid holding these for a long period of time.

Another option in anticipation of a market crash is to buy the VIX.  There are different ETFs you can buy, including leveraged ones.  This is a measure of the volatility index.  It tends to spike up during a market crash.  You can make big gains in a short period of time with this if you guess correctly.  Just be aware that the reverse is true and that you can lose quickly too.

One of the specific things mentioned in this comment was about what to do in a 401k plan.  This is hard to say because these plans vary so much.  Aside from the above suggestions, there are mutual funds you can invest in that benefit from a down market.  However, if your options are really limited in your 401k plan, then the best thing to do might just be to move it to a money market fund, if you anticipate a coming recession.

The most important thing in investing is capital preservation.  You don't want any really big losses that will make it hard to recover.  That is why I recommend the permanent portfolio.  But if you are really anticipating a stock market crash, then the most important thing is to sell your stocks before everyone else starts selling.  Any profit you can make in such an environment is really just icing on the cake.

1 comment:

John (Ad Orientem) said...

IF one has a very high degree of confidence in one's crystal ball, AND you are playing with money you can afford to lose, AND you are just so sure that the stock market is about to blow up, my speculative move would be...

1. Long US Gov't LTT's. I'd probably use EDV since that is basically Treasuries on steroids.
2. Short the stock market. I would probably go with something like SDS. (2x short S&P 500)