Managing a Stockmarket Crash

Ultimately determines your long-term investing success!

A stockmarket crash is a fact of life that value investors need to be prepared for.

How well you handle a stock market correction (more than a 10% fall) or a stock market crashes (more than a 20% fall) will ultimately determine your level of success as an investor over the long term.

AS A LONG-TERM VALUE INVESTOR, YOU HAVE TO BE PREPARED TO MANAGE A STOCK MARKET CRASH. WHY? - BECAUSE THEY ARE GOING TO HAPPEN FROM TIME TO TIME!

Think back to the 1987 stock market crash and the more recent 2007-8 global financial crisis.

These stock market downturns (a polite phrase for a correction or stockmarket crash) , provide opportunities to purchase stock in wonderful businesses whose stock prices have been swept down in the tide of fear.

Here is an optimistic view from Confucius which you may be able to relate to stock market crashes ...

Our greatest glory is not in never falling, but in getting up every time we do. (Confucius, 551-479 BC)


The Current Financial Crisis

The recent and ongoing global financial crisis and accompanying stock market crash does not appear to be leading us to a 1930s style depression. Here are some reasons ...

• Fiscal packages have been put in place by major western governments, compared to a lack of spending and borrowing in the early 1930s
• Lender of last resort and bank guarantee policies have been implemented this time, whereas thousands of banks failed in the early 1930s and depositors lost money
• No major protectionism moves have resulted from the current crisis, whereas a crash in trade caused by tariff raisings and import restrictions occurred in the 1930 depression.

So things look somewhat different this time as governments appear to have taken heed of the causes of the 1930s depression.

A number of signs, or so called 'green shoots' of hope, are starting to appear which suggest that the worst is over.


Characteristics of Stock Market Crashes

Panic selling is commonly associated with a stockmarket crash. This is evidenced by wholesale selling of stock, causing a sharp decline in price.

Investors just want to get out of the investment, with little regard for the price at which they sell.

The speed of the market decline may be exacerbated by automated stop losses, pre-arranged sell orders, and the entry of short sellers into the market, selling stock that they don't own and buying it at lower prices to make a profit.

Margin calls on margin loans may cause the downturn to be even worse.

The main problem with panic selling is that investors are selling in reaction to pure emotion and fear, rather than evaluating fundamentals. Almost all stock market crashes are a result of panic selling.

In the case of individual stock crashes, stock exchanges may place a market halt on a particular stock in order that the market can better digest the reason for the fall.

Terms associated with a stockmarket crash include a dead-cat bounce which describes a temporary recovery of a market from a decline, after which the market continues to fall.

A falling knife is a term given to a stock whose price or value falls sharply in a short period of time. The term suggests to me that you might get bloodied (lose money) if you try to catch it (buy it) on the way down.


Predicting a Stockmarket Crash

If you think that predicting a stockmarket crash is something that you might get good at - THEN FORGET IT!.

Unlike the slow and relatively steady rise in prices that occurs in a bull market, stock market crashes are swift and sudden.

If you are not convinced, ask yourself if you know anyone who predicted the recent global financial crisis (GFC) and the resulting debacle!

The first signs of trouble is usually increasing euphoria in the financial press which gradually gives rise to heightened interest by the general public. This can reach the point where everybody wants to buy shares, and shares become part of dinner table conversation.

When all your friends want to talk about shares, you know that it is time to think about selling!

The stock market index provides another rough clue. When the market index approaches historic highs, it is time to be cautious.

The overall price earnings ratio for the market is another clue. Overall market P/Es commonly vary from a low of about 12 to a high of about 20 with an average of about 15 to 17. Less and less shares appear undervalued as the average market P/E increases.

Interestingly, the recent stockmarket crash did not show the signs of inflated P/Es, as company earnings were historically high due to companies taking on excessive debt.

While this debt helped to artificially inflate earnings, P/E ratios were not historically high - because earnings appear on the denominator of the P/E ratio. It was a debt-led crash.

This says something about relying solely on P/E ratios as the indicator of market overvaluation.


Preparing For and Responding to Crashes

As the market index and average P/Es rise in a bull market, particular shares in my portfolio start to become overvalued.

I compare its P/E ratio to its historical highs and lows for the last few years. If the value gets close to, reaches, or exceeds the average historic high, I commence a staggered sell.

I do this for other companies in my portfolio as the market heats further. As I do this, my margin loan reduces from a maximum loan valuation ratio (LVR) of 40% and heads down towards 20% - or my stock investment account grows.

Somewhere along the line, a stockmarket crash or downturn occurs. Inevitably, I will still be invested to some extent, but at a lesser level.

But I will have accumulated a cash holding, and CASH IS KING AFTER A MARKET CRASH! - or I will have reduced my margin loan sufficiently to be in a position to start staggered buying back into the market - and quite likely back into the same stock that I sold off previously.

Staggered selling followed by staggered buying is an important strategy for me. Since no one can pick the top of the market - and a staggered sale allows me to enjoy some more upside if the market continues to rise.

I ACCEPT THAT THE MARKET MAY CONTINUE TO RISE! ... and I view this as part of the exercise ... but being able to sell some more stock helps to ease the concern of thinking that I have exited too soon.

The opposite situation arises for staggered buying after the downturn. If I do a staggered buy when the market looks as if it is getting some life ... and then a dead-cat bounce occurs, I have the opportunity to buy more stock at a lower price.

Of course there are two downsides to this strategy that I accept. The first is that I have to pay more brokerage than I needed to, as I am going to be doing extra buying and selling than normal.

The second downside is that the market may fall faster than I anticipated. Depending on the stock, if I am still making a good profit as the market drops to a lower price for the stock, I will sell anyway and not be too concerned.

It is common to under-estimate how far prices can fall, so I do not want to be holding over-priced stock that is likely to fall further.

And the opposite case is that the market may rise faster than I anticipated as it recovers from fear and depression. Missing a small part of the rise in the price of some stocks that I buy into is something that I am happy to accept.


Self-Funded Retirees

In this discussion, I should not forget retirees who are enjoying income from retirement/superannuation funds, self-managed or otherwise. They are also in a position to ride out stock market crashes in a sensible manner.

As we are all living longer, it is important that our assets have exposure to the share market, since it offers the best returns over the long term.

As most of us will live for some 20 to 25 years after retirement, funding retirement is, from the beginning of retirement, still a long-term investment. So it should be exposed to the best returning asset class ... namely shares, in order to make it last by allowing for growth over time.

But retirees, unlike most other people, need to withdraw funds regularly to cover living expenses and other purchases.

The strategy I use is to insulate three year's living expenses, together with any major purchases I am planning to make in that time, in cash and bonds - and put the remainder in equities, local and international.

This means that the assets can better ride out a stockmarket crash by having living expenses withdrawn from the less volatile cash and bond component rather than having to sell more volatile shares, the price of which are depressed during a market crash.


To Conclude

There are several ways I have been able to partially insulate myself from these potentially catastrophic events called stockmarket crashes.

I have learned this from experience as I have gone through several stock market crashes in the past ... and they say that experience is the best teacher.

If you haven't experienced a stockmarket crash, but you can learn from other people's experience, then the pain of having to learn the hard way can be minimized.

It is these inevitable events that give rise to the best opportunities to buy the best businesses at prices below their intrinsic value ... and that is what value investing is all about!

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