The Fund Library :: Columns :: Investing for the next market crash

In recent weeks, there has been a lot of talk about the potential for a big market correction as we head into the summer and the fall, which has historically been the most volatile period for stocks. There are many reasons for some concern, with valuation levels leading the pack. While lower rates may help justify inflated valuations, it’s difficult to believe that price-to-earnings ratios of more than 21 times is sustainable into the future, particularly when the longer-term average is closer to 15. If we get a regression to the historic average, that’s a nearly 30% drop in value.

One notable supporter of the correction forecast is Harry Dent, the economist who called the collapse of Japan, the dot-com bubble, and the 2007 housing bust. Mr. Dent is now predicting what he calls, a “once-in-a-lifetime crash” in the next three years. He has long been known for his bold predictions, and his current expectation that stocks will drop between 70% and 90% in the next three years. If that were to happen, we’d see the S&P 500 fall from its current level, roughly 2,430, to between 243 and 729.

Demographics, debt, and real estate

The foundation for Mr. Dent’s bold forecast is demographics, and specifically that the Baby Boomers are now getting older and starting to die. According to his research, the generations after the Boomers are not large enough to replace the Boomers’ spending and consumption, which could be disastrous for the economy and markets.

Another factor cited was the high level of debt carried by consumers. There was some deleveraging that happened after the 2008 financial collapse, but today, debt levels have again reached worrisome heights. In the U.S., consumer debt is now at levels in line with 2008. Here at home, consumer debt reached 167% of disposable income in the first quarter of 2017. Should we see any meaningful increase in interest rates, the cost of carrying these elevated debt loads will also increase, eating away at consumers’ spending power, creating a drag on economic growth.

There are also concerns around the fragility of the global real estate market, and geopolitical concerns, which on top of the demographics and debt levels, creates an almost “perfect storm” for a major market correction.

Now before you pack up the car, head to Costco to load up on canned goods and shotgun shells, and move to a cabin in the woods, I’d suggest you take a deep breath, and relax. The forecasts by commentators such as Mr. Dent are designed to create headlines, and ultimately sell books and newsletter subscriptions.

Déjà vu all over again

Yes, markets are overvalued; yes, debt levels are high; yes, the housing market is potentially in a bit of trouble; and yes, there are lots of worries around the world. But that does not mean that there will be an unprecedented market crash. We have seen much of this before. While we are unlikely to see a crash, it is highly likely we will see a pullback or at least some period of below-trend growth. Unfortunately, there is no way to tell in advance how this will play out, or when it will play out. As John Maynard Keynes is believed to have said, “Markets can stay irrational longer than you can stay solvent.”

As an investor, times like these can be challenging, to put it mildly. However, it is times like these where we must stick to our discipline and focus on the bigger picture. A crash may be coming, but it’s far from a certainty, and to position portfolios for such a binary outcome may end up doing more harm than good.

Instead, it is best to look at our investment goals and figure out how much risk we are comfortable with. People rarely worry about risk and volatility when things are going well. Then when things get bad, they tend to overreact and make choices that often hurt more than they help. We must realize that market corrections are part of investing, but if we have built a portfolio that is in line with our needs, they are certainly very manageable, particularly over the long term.

Portfolio planning

I continue to keep my asset mixes in line with the longer-term averages. Equities are expensive now, but looking out over a five-year time horizon, they are still expected to deliver a higher level of return than bonds. Turning to bonds, while the return expectations may be muted, they still need to be a healthy part of your portfolio. If we see a market correction, it is the bonds in your portfolio that will act as a ballast to help protect your capital. In most corrections, bonds move up, while stocks move lower.

With your investment selection, I would suggest you focus on higher-quality securities, trading at reasonable valuation levels. Look for funds and ETFs that focus on strong underlying businesses, as it is these businesses that are expected to withstand any correction better than those highly levered companies.

If you have had your portfolio invested for some time, it’s a good idea to rebalance back to your target asset mix. This takes some profits off the table, and reduces your risk over the long term. Finally, if you are extremely worried about a market correction, you could always get more defensive by holding a bit more cash, and reducing your equity exposure by adding to your investment-grade bond holdings.

There is no perfect solution for uncertain times, but having a strategy and the discipline to stay the course will likely lead to better long-term results than making bets on the unknown.

Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson’s Top Funds Report, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.

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