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Five Essential Steps to Prepare for the Next Bear Market

By Alexander Green, Chief Investment Strategist, The Oxford Club
Thursday, September 29, 2016

"Stop scaring the pants off me," a reader wrote last week.
 
That's not my goal. Yes, I've told my readers my concerns about negative interest rates – a first in the 5,000-year history of civilization – and mounting sovereign debt.
 
But I'm not suggesting that you run to cash. That's rarely a smart move, even when yields aren't microscopic, as they are now.
 
It's just that we're seven years into the economic expansion (weak as it is) and seven-and-a-half years into this bull market, and – as the old saying goes – trees don't grow to the sky.
 
Are you prepared for the next downturn? You should be. But you should also be prepared to participate in this bull market as long as it continues.
 
What I'm saying isn't the least bit contradictory. Just take these five essential steps...
 
1.   Make your asset allocation more conservative.

How you divide your money up among stocks, bonds, real estate investment trusts, and other assets is your single most important investment decision. You make your asset allocation more conservative by reducing your exposure to equities. Just how conservative to make it is a personal decision based on your age, temperament, and risk tolerance.

But Warren Buffett's mentor Benjamin Graham had a good rule of thumb: An investor should never have more than 80% in stocks or less than 20%. So unless you have one foot in the grave and the other on a banana peel, don't get more conservative than that.
 
2.   Favor large-cap stocks over small-cap stocks.

History shows that large caps hold up better than small caps in a market downturn. (Just as small caps outperform large caps early in an upturn.) If you want to be even safer, opt for overweight mega-cap stocks. (Those are companies with a market cap of $100 billion or more.) A few examples are Wal-Mart (WMT), Apple (AAPL), Toyota (TM), and BP (BP).
 
3.   Favor value stocks over growth stocks.

Growth stocks are companies whose profits are growing much faster than average. Value stocks are companies that are cheaper than average based on price-to-sales, price-to-earnings, and price-to-book value. Value stocks offer a higher margin of safety – and hold up better in a bear market.
 
4.   Favor dividend-paying stocks over non-dividend-paying stocks.

Some companies are growing so fast that they need to use most or all of their cash flow to finance their growth, so they are unable to pay dividends. But companies that are mature, stable, and profitable generally do pay dividends. Those yields will support them in a down market – and provide you with an income stream.
 
5.  Tighten your stops.

I recommend a 25% trailing stop on longer-term positions and tighter stops on short-term trading positions. But feel free to run your stops tighter if you are older, have big gains, or are concerned about the tone of the market.

Just don't run those stops too tight. You want to give your stocks room to breathe. You want to avoid stopping out when a stock is still in a confirmed uptrend. (That generally means it is trading above both its 50- and 200-day moving averages.)
 
Why not just move to cash if the outlook for the market is cloudy?
 
This idea – called market timing – can seem like a good idea. After all, you can get out before the real trouble starts, and then get back in when the outlook improves.
 
Keep dreaming...
 
You may get out of the market, but it keeps going higher instead. Then, having missed the rally, you might be in for the next correction. That's not good. Yet stay out even longer – as some people have since the Great Recession – and you might never get back in.
 
Even if your short-term call is right and the market tanks the day after you move to cash, when will you get back in? Nobody rings a bell at the bottom either. Investors often feel so good about missing the downturn that they miss the upturn.
 
Plus, if you sell everything and go to cash, Uncle Sam is going to hit you with a huge tax bill on your capital gains.
 
So don't get out of the market. Just make your portfolio more conservative using the five steps I've outlined here. This way you're protected if the market goes down, but you're participating if the market keeps going up. That's what intelligent risk-taking is all about.
 
Good investing,
 
Alexander Green




Further Reading:

Most investors live in fear of the next bear market. But as Alex explains, you shouldn't. See his reasoning here: Should You Be Afraid of a Bear Market?
 
"If you buy at some point in a bear market, even if you are a bit early, you are almost certainly doing the right thing from a long-term perspective," Alex says. Learn more here.

Market Notes


A LOOK AT THE CURRENT STATE OF THE U.S. ECONOMY

Lots of folks are saying that the U.S. economy is stalling, but two important gauges are saying otherwise...
 
One of the simplest ways to measure the state of the economy is to look at consumer confidence and spending. When people are confident about the economy and the stability of their jobs, they tend to spend more money on things like electronics and clothes. When confidence is low, people tend to hold on to their cash.
 
In today's world, you can simply look at the strength or weakness of large shipping and retail companies to figure this out. Americans are increasingly turning to e-commerce sites like Amazon (AMZN) instead of brick-and-mortar competitors. Those orders then need to be delivered to the customer by companies like FedEx (FDX).
 
As you can see from the following chart, Amazon (the blue line) and FedEx (the black line) just hit new 52-week highs. It's a good sign that the U.S. economy is chugging along...
 

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