Wall Street is off to a terrible start to 2016. The broad indices are falling — as of this writing, the S&P 500 is off 8% in just three weeks — major technical indicators are now in bear market territory, overall economic data is miserable and earnings are being revised downward.
None of this is good for the market, and I think we are headed for more downside — possibly a market crash.
So what precautions can you take against a stock market crash? Well, a lot depends on your own risk tolerance. There are many choices, and the level of your conviction will determine the strategies that are best for you to prepare for a market crash.
I have 10 suggestions, from conservative to aggressive. And as a note: My strategy in general with a stock market crash is to do a little bit at first, and as the decline gets worse, pile on to the strategy even more.
#1: Always set stop-losses. You’re not always going to be hovering over your computer ready to tinker with your brokerage account at a moment’s notice. And that’s why the stop-loss order is an investor’s best friend. A stop-loss order simply lets you sell your stock at a predetermined price, or buy shares once they hit a certain price. You can do these either on a dollar basis or a % basis. So, for instance, you could set an order to sell your shares of Apple Inc. (AAPL) once they’ve fallen 10% from the time of the order, or you could set an order to sell your shares of Apple once they reach $90. You decide how much pain you’re willing to endure, and let the market do the rest.
#2: Stay the course. The easiest and best choice regarding a market crash is to do nothing. If you own a long-term broadly diversified portfolio, you can ignore the market and focus on the long-term, because 30 years from now this decline will look like a blip. My biggest lesson in diversification came during the financial crisis. The market was down 55% at its worst, but my broadly diversified portfolio was only down 35%. That might sound like small consolation, but considering I clawed my way back to breakeven before the rest of the market, then went positive before anyone else, I felt pretty good about my overall strategy.
#3: Raise cash. If I believe in a company and it is up significantly since I bought the stock, I won’t touch it. For example, I’m sitting on a 70% return in Walt Disney Co (DIS) even with the current decline. I don’t care. The company will survive. However, if I own a position that is 5%-7% from breakeven, either up or down, I will sell out and take the cash. The idea is that if I truly believe we are heading lower, I can get back into the same stocks at lower prices, or reallocate to other opportunities that become available.
#4: Hedge with modest short positions. One thing I’m doing right now is hedging my overall portfolio by deploying available cash into some inverse ETFs. This will give me downside protection against my long positions that I intend to hold. I opened a 2x leveraged short in the S&P 500 using ProShares UltraShort S&P500 (ETF) (SDS), short the MidCap 400 using ProShares Short MidCap400 (ETF) (MYY), short the Nasdaq 100 via ProShares Short QQQ (ETF) (PSQ), and am shorting the Russell 2000 via ProShares Short Russell2000(ETF) (RWM). This all comes to about 20% of my total portfolio, so I haven’t shorted everything, but I have set up a solid short position to hedge.
#5: Sell covered calls. You can use options to hedge your positions as well. Take any stock or ETF you own, then sell covered calls against it. That means you are being paid so someone else has the right to purchase your position from you at a given price on or before a given date. So you collect money for selling the contract, and if the stock price is not above that strike price you contracted at, you also keep the stock. Thus, you’ve collected some funds against your position that hedges your downside. Now, you will pay capital gains taxes on those profits, but you may end up offsetting them if you harvest losses during the year. (Here are a few trade ideas on that front.)
#6: Purchase puts. The opposite of selling covered calls is to buy puts on any stock or ETF, whether you own it or not. Here, you are buying the right to “put,” or sell, that security to someone at a given price on or before a given date. You don’t have to hold the stock, because your broker will trigger a matching buy order at that same price. It’s a bit like shorting a stock, except you don’t actually borrow shares to sell until the exact moment of execution, when the shares are then immediately purchased by the put seller. If the price falls below the strike price you contracted for, plus what you paid for it, your difference is the profit. Thus, you’ve made money on the downside.
#7: Short Highfliers. Another alternative, if you really believe the market is going to fall, is to hold onto your longs but short the highflying stocks. These are the most vulnerable to fall with the overall market. Stocks like Netflix, Inc. (NFLX), Tesla Motors Inc (TSLA), Google (GOOG, GOOGL) and Facebook (FB) are the companies I’m suggesting. You have to be quick on the trigger and very nimble. If the market turns back up, they could regain momentum. However, on the downside, they are likely to fall more than the overall market, meaning you may be able to hedge your long position very efficiently.
#8: Reallocate equities into exchange-traded debt. This is a strategy that I just thought of last week. The stock market has been in a terrible place, yet exchange-traded debt is doing just fine. In fact, many issues are seeing buying interest and pushing prices up. Even when they went down, they didn’t fall nearly as much as the overall market — not even close. The reason is that this is debt and not equity. It’s much safer to invest in debt, so consequently the ETDs tied to debt issuances are becoming a kind of safe haven. You can even get paid interest while you wait out the tough time.
#9: Reallocate equities into preferred stock. This is basically a similar concept as moving into ETDs. In this case, you are moving out of common stock to a stock-bond hybrid that is preferred stock. Most of these issues have been relatively stable as well. Preferred stock is tied to only one thing — a company’s ability to make good on its preferred dividends. Well, the common stock falling due to a lousy market has virtually no bearing on this issue. Thus, you can move into preferred stocks, which will hold value and pay dividends quarterly. Remember, though: Selling out of stocks may trigger capital gains.
#10: Sell out and go short big-time. Frankly, I don’t advise this except for aggressive traders. This isn’t investing. Here, you are selling out of all your long positions, taking whatever capital gains or losses with you, and shorting the heck out of the entire market and/or individual issues. Now, if you think the market has a definitive short- to medium-term bias, then go for it. You can do very well. On the other hand, be aware that the market’s long-term expectation is to go higher. So you have to know exactly when to cover your short position, lest you get caught in a monster rally.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he was long DIS, MYY, PSQ, RWM and SDS. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.