Is the Stock Market Going to Crash?

You may have noticed a couple of very bad days in the stock market this week. With the markets losing about seven percentage points in just two days, you may be wondering: is the stock market going to crash altogether?

But this is a flawed question. Because nobody knows when the stock market is going to crash and burn. 

But that doesn’t mean there’s nothing you can do about this to preserve your wealth. Or even take advantage and reap gains. So if you’re one of the people wondering if the stock market is going to crash, you should read on.

Just a Few Bad Days – Or Is the Stock Market Going to Crash?

Bear markets are inevitable. But losing thousands of points in the span of a day or a few days? These are rare events and nobody knows when they will occur.

Stock market crashes have been referred to in the past as “black swan events.” That’s because they’re rare and nobody can anticipate when they’ll happen.

So far there have been four major stock market crashes in US history:

1. 1929 – which initiated The Great Depression
2. 1987 – “Black Monday the 2nd”
3. 1999-2000 – The “Dot Com Bust”
4. 2008 – “The Great Recession”

The important thing to do is to protect yourself against such black swan events – stock market crashes – precisely because you do not know when they may occur. Does this mean you should never invest? Or take all of your money out of stocks?

NO! Absolutely not. What it means is that you should have a plan. Actually, you should always have a backup plan. As Andy Snyder of Manward Press likes to say, “We don’t have a plan unless we have a backup plan.”

Your main plan is how you make money when things are going well. Your backup plan is how you will protect your wealth – even make money – when things are not going so well. Having a backup plan is essential.

In this article, we will discuss several ways you can protect your money from a stock market crash. When is the stock market going to crash? The “when” is irrelevant if you put these strategies in place. But first, here are some reasons why the stock market could be at risk.

Why the Market May Be at Risk The Market Could be Overvalued

In theory, the price of a stock should correspond to what it’s really worth. That’s also true for the stock market as a whole. Unfortunately, things do not usually work out so neatly.

How can you tell if the stock market is overvalued? Meaning, that the actual prices of stocks are much higher than they really should be.

One good way to evaluate this is by looking at the price-to-earnings ratio (PE ratio) of the market as a whole. This measure can be calculated by taking the aggregate price of a stock market divided by all of the earnings of its component companies.

The higher the P/E ratio, the higher stocks are valued compared with $1 of earnings. So for example, let’s say the P/E ratio is 10. That means for $1 of earnings, stocks will trade for $10. If total combined earnings were a billion dollars, then the aggregate price of the stock market would be $10 billion.

In the period from January 1971 to June 2017, the P/E ratio of the S&P 500 averaged 19.4  The median P/E ratio was 17.7.

The P/E ratio of the market right now is around 23. That means that there’s a good chance that the stock market is overvalued. There won’t necessarily be a crash. But a bear market may be likely to occur sooner than later. And sharp drops in stock prices are possible.

Bubbles

Similarly, a particular asset or sector of the market may be experiencing a bubble. Like a high P/E ratio, a bubble is when an asset or sector becomes highly overvalued compared with its intrinsic worth.

There have been several major bubbles that have burst over the last few decades. One you may remember well is the dot-com bust of the early 2000s. That one infected the tech sector. It was caused by the wild overvaluation of tech stocks compared with wild speculation about nonexistent earnings. 

Another one you may remember well is the crash of 2008. This one was caused by the bad lending and pricing of mortgage derivatives. It was triggered by mass foreclosures on bad mortgages. If an underlying asset blows up like it did in this case, it can have devastating impacts on derivative securities.

Is there a bubble to be wary of now? We don’t know! But one way to protect yourself from bubbles is to make sure you have a diversified portfolio. Even if you are heavy in stocks, this will protect you from a particular sector of the stock market imploding.

It’s never a bad idea to have some of your assets in other instruments, as well. These could be anything from bonds, crypto, cash, gold, or even works of art.

However, if a bubble bursting triggers a marketwide crash, stock market diversification alone isn’t going to help you. You’ll need to have some other strategies

Let’s look at one more market factor that can play a major role in triggering a stock market crash. 

External Triggers

Usually stock market crashes are triggered by external events. You know, like the current Coronavirus scare we are experiencing right now.

Other events that have acted as market triggers in the past included the 9/11 terrorist attacks, an earthquake, and even an Iranian War.

Will the Coronavirus trigger a stock market crash? We don’t know! What we do know is that fear of a true global pandemic has the chance to be a black swan event.

So it is essential that you be prepared in case the stock market is going to crash.

Bear Market Strategies You Should Consider

Here’s where we get to your backup plan. There are three important strategies you should continue to protect yourself from a bear market. Those three strategies include:

1. Trailing Stops
2. Inverse ETFs
3. Derivative Plays / Stock Options

Let’s look at each one of these:

Trailing Stops

Trailing stops are a trading strategy based on the placement of stop-loss orders. A stop-loss order is a sell order that instructs a stock to be sold at a certain price if the stock hits that price on a downslide. 

For example, let’s say you purchase a share of Amazon stock at $10 (keep dreaming though). You could set a stop-loss order at $7 so that if the stock drops to $7, it is sold and you limit your losses to $3.

As outlined by my colleague Amber Deter in the article I linked to above, there are three main types of stop-loss orders:

1. Stop-Loss Market Orders
2. Stop-Loss Limit Orders
3. Trailing Stop-Loss Orders

We will focus on the third strategy here. A trailing stop is an order to sell a stock at a certain percentage below the market price. As the price of the stock rises, the sell price of the stock rises along with it.

For example, let’s say you have a 20% trailing stop loss on a stock you bought at $15. If the stock loses 20% of its value and drops to $12, the order will be triggered and you will sell the stock. However, if the price of the stock climbs above the $15 purchase price, your trailing stop-loss order climbs as well. 

If, for example, the stock climbs up to $20, the trailing stop-loss will be triggered if the stocks loses 20% from its current market price. 20% x $20 = $4. So if the stock drops to $16, it’s time to sell. This can prevent greater losses.

A good general rule of thumb from The Oxford Club: set 25% trailing stops on your investments unless there’s a good reason not to. That way, you’ll protect yourself from major losses and be able to lock in some of your gains if the stocks climbs and then backslides.

Inverse ETFs

An Inverse ETF works opposite to a traditional index ETF. For example, an ETF that aims to mimic the S&P 500 will generally increase in price as the S&P climbs and decrease as the S&P falls.

An inverse S&P 500 ETF would do the opposite. It has a negative correlation with the index or sector it is trying to mimic. 

Inverse ETFs are able to accomplish this feat by holding a combination of assets and derivatives, such as options, aimed to move against the market. They are considered risky assets. Therefore, investors should be careful with them.

But they can be useful in managing downside risk against the broader stock market. It is a hedge against a market crash. If the market does indeed crash, the inverse ETF will increase significantly. 

Like standard ETFs, these can enjoy advantages such as liquidity and ease of trading, lower fees than other funds (like mutual funds), and positive tax consequences.

Although inverse ETFs are risky, they can still be less risky than other hedging strategies. Shorting a stock is one hedging strategy that can be particularly risky. In fact, it has unlimited amounts of risk.

For that reason, inverse ETFs may be one way to look to lessening the effects of a stock market crash on your portfolio.

Using Stock Options to Hedge a Market Crash

A third alternative available to you is to use stock options to hedge against a stock market crash. A put option gives you the right to sell a stock at a particular price.

You can see the advantage of put options during a market crash. If you own a put option that allows you to sell one share of a stock at $30, and that stock crashes down to $10, you can still sell that stock for $30 and earn your $20 spread (less the purchase price of the option itself).

There are many options strategies you can deploy in order to hedge against a market crash. Another option would be to invest in an ETF that would do similar work for you. One example of this is the Cambria Tail Risk ETF (CBOE: TAIL) which holds a combination of out-of-the-money put options as well as treasuries.

So… Is the Stock Market Going to Crash?

Like I said before – I don’t know! And neither do you. Which is why it’s always good to have a backup plan, just like Andy Snyder says.

Now that you know how to identify triggers for a potential stock market crash, you can keep a vigilant eye out for any of the three major indicators above. One might be coming down the pike.

And now you also have some strategies to help you deal with a market crash in the event that one does. 

Investment U is full of ideas on what to do in the event of a crash or a bear market. And we have even more ideas to help you make tons of money regardless of how the stock market is currently doing. So be sure to sign up for our free daily e-letter so you can stop asking yourself, “Is the stock market going to crash” and start making money – now.

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