What to Buy in a Market Crash

Monday August 8th, the first trading day after S&P downgraded U.S. debt, was a crash day in the American stock market. Asia held up much better and so did much of Europe, except for Germany. 

The Dow Industrials were down 635 points (5.55%), the S&P 500 was down 80 points (6.66%), Nasdaq was down 175 points (6.90%) and the Russell 2000 64 points (8.89%). The DAX in Germany was down slightly more than 5%, whereas the Nikkei in Japan and the Hang Seng in Hong Kong were down a little more than 2%. A crash is traditionally defined as a drop of 5% or more in a day. The Nasdaq and Russell 2000 already had a crash day last week. U.S. stocks had numerous crashes during the Credit Crisis in 2008. 

Stocks looked like they were about to enter freefall – a severe uninterrupted drop – around 3:00PM. President Obama delivered a statement on the S&P downgrade and caused a temporary short-term move up instead. The market would have washed out otherwise and been ready for its first rally. 

As is the market is at the end of its first stage of selling, we may just have to wait a little longer. The technical indicators on the daily charts have either hit their lowest points or are very close to them. Some short covering and opportunistic buying should lead to a quick sharp rally for a few days. This rally is for traders only. The weekly technicals have yet to bottom out and nothing longer term should be expected. 

Technical bottoms and price bottoms are not the same. The technicals will have to gather some strength before stocks can enter a new rally phase. The ultimate price bottom is probably as much as two months out, which would put it somewhere in October. Until then, choppy action that brings the indices intermittently lower should be expected. While the indices may not go a lot lower, individual stocks, especially small cap, high-beta stocks (those known for their volatility) can indeed go much lower. This also includes high flyers that have yet to have had a big drop. In major selloffs, almost everything goes down. 

Once a bottom is established, the volatile stocks you wanted to avoid in the selloff are the ones you want to own. This is where you will make the most money. Small, emerging, and leveraged are the keys. Smaller cap stocks will go down the most and then back up the most (just make sure the drop was market related and not because the business of the company is threatened). Emerging markets, both the BRICs (Brazil, Russia, India, and China) as well as smaller ones will have the same up and down behavior. Russia was down 12% on August 8th for instance. You will do better still if you use leverage on your buys. There are ETFs that provide 200% and 300% exposure. For the emerging markets, these include LBJ (300% Latin America), YINN (300% China), RUSL (300% Russia), EDC (300% Emerging Markets), INDL (200% India) and UBR (200% Brazil). For small cap stocks, TNA (300% long the Russell 2000 index) is the most leveraged play. 

Traders should be able to make good use of these ETFs to move in and out of the market. Investors with a long-term perspective will want to wait until a market bottom has had time to fully develop.

Daryl Montgomery
Author: Inflation Investing – A Guide of the 2010s

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.Investing is risky and if you don’t feel capable of doing it yourself, please seek professional advice.