Correction or Crash? Four actions to take to protect your portfolio

Four Actions to protect your portfolio from a Market Crash or Correction
Market Crash or Correction

January closed on a downbeat as the markets lost momentum from the 2013 buyers. Now, with the leading indices pushing for new medium-term lows, the million dollar question is whether we are in a stock market correction or if we are heading for a Crash!

Year to date, the ASX200 index has lost 255 points or 4.7% (up to the 4th February). Across the Pacific Ocean, our big brother, the US stock market, has lost a little more. Down 5% on the S&P500 index. It wasn’t too long ago that a 5% change in the stock market instilled fear amongst investors and was considered a Crash!

The definition of a stock market correction, as defined by investopedia.com, is “a reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for overvaluation … are usually temporary price declines interrupting an uptrend in the market or asset … has a shorter duration than a bear market or a recession, but it can be a precursor to either.”

Imagine the pain of a ‘real’ stock market crash

Compare this to the definition (same source) of a stock market crash: “a rapid and often unanticipated drop in stock prices … can be the result of major catastrophic events. Economic crisis or the collapse of a long-term speculative bubble.”

With these definitions in mind, the billions of dollars that have been wiped off the markets so far in 2014 is merely a pullback and not even a Correction or Crash! If that is the case, imagine the pain of a ‘real’ stock market crash. Such as in 1987 or 2008!

If we find the current market movement continuing on the way down, we need a further 5% decline in the leading indices. That is the ASX200 and/or S&P500. These indices have already interrupted the uptrend. Forming lower low points and suggesting a potential change in trend might occur.

However, some would argue that we have a reason for the markets to pull back:

  • The Fragile Five, that is the emerging markets that are poised to slip into a Recession, are triggering a flight to safety for foreign investors
  • Tapering of Quantitative Easing (QE) by the US Federal Reserve
  • Weaker Manufacturing data from China and the US
  • US Debt Ceiling on the brink of defaulting debt payments


Not all is doom and gloom

Not all is doom and gloom however. The International Monetary Fund (IMF), in their World Economic Outlook (WEO), stated in the Jan2014 release that “Activity is expected to improve further in 2014-15 largely on account of recovery in the advanced economies … Global growth is now projected to be slightly higher in 2014 at around 3.7 percent, rising to 3.9 percent in 2015.”

Despite the fragility of Emerging economies, the consolidation of China’s GDP growth rate. And the slow recovery in the US and Europe. Economists are generally consistent in their expectations for a positive growth year on a global economic level.

An early decline in the markets for 2014 is a buying opportunity after a strong 2013. As the markets pushed higher in December and into January. Our view was that the markets were overbought. That is, there was little more upside when you compare the growth of the stock market to the economic data.

ASX200 and S&P500

Through 2013, the ASX200 index gained 841 points or 18.6%, while the US S&P500 index gained 329 points or 23.0%. This is a sizeable gain for any given year, let alone one that is in a “recovery” mode. Although the ‘Mum & Dad’ investors see a strong market as being an opportunity to get on board for the ride, institutions and savvy investors are more wary of the disparity.

This market pullback could offer investors an opportunity to buy up stocks at better prices, and help push the broader markets into higher highs through the remainder of the year. The key is not to attempt catching a falling knife but to identify when the current selling pressure eases and buyers return.

What we are looking for now is the reaction of the markets over the next week or two. If we get a short-term rebound, we will evaluate the strength of that rally. Any signs of weakness and a bearish reversal on a rally will denote a lower high and the potential of a market change in trend. This will be pivotal.

Should we see the markets continuing to slide from here on in, then panic and fear will start to take control of investor decisions. The 10% decline in the markets will soon be attained and a market correction defined. But if this happens very quickly, then look out for the headlines of a stock market crash.

How do you protect yourself if it all turns to custard?

How do you protect yourself if it all turns to custard?
How do you protect yourself if it all turns to custard?

Firstly, don’t fear closing your trades. I know the age old response from your advisor has always been to ride through any market pullback. But if we have a strong downtrend it could take years before it recovers. Just look at how long it took for the markets to return to their highs from 2007 through 2013.

If selling your stock is not the preferred choice, either because of tax reasons or if you are emotionally attached, then consider protecting your portfolio by purchasing a Put option on a market index.  And if you are unfamiliar with a Put option, in its simplest form, it gains value as the stock market falls. If you purchase a put option on say the ASX200 index or S&P500 index, then you have the opportunity to offset or hedge the decline in your portfolio value.

Adopt Bearish strategies using options and/or stock. There are numerous strategies that are available that benefit from non-directional markets or declining markets. Balancing your portfolio to include variations of these strategies can help protect your portfolio against falling markets.

Contact Us today to learn more about options strategies through our Options Made Easy and Options Mastery Course.

Finally, above all else, Don’t Panic! Most Mum and Dad investors will hold onto their stock through a market crash, hoping and praying the pain will end. They eventually can bear the pain no more, sell their stocks, and that is when the stock market turns around. If you have selected sound companies that provide good long-term growth and not speculative small-cap stocks on the hope they make you rich, and diversified soundly, you will always ride through a Correction or Crash.

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