How We Manage Large Declines

Includes: EPRO
by: Roger Nusbaum

My response to a relatively new client's question about how we manage downturns in the stock market;

In general terms the market can only do four things. No matter what is going on in the world the market can only go up a little, up a lot, down a little or down a lot. We are most concerned with that last one; down a lot. There are two different kinds of down a lot; fast declines and slow declines.

Fast declines historically are better to buy while slow declines are better to sell. An example of a fast decline is the 1987 crash. The low was a day or two after the crash and from there was an almost uninterrupted multi-year up move. Slow declines tend to be far more serious but fortunately the market does warn with things like an inverted yield curve, downward slope in the S&P 500's 200 day moving average and the 2% rule. The 2% rule is when the market averages about a 2% decline for three months in a row. I would say to focus less on the literal meaning and more on the gradual decline over a period of several months.

This indicator provided warnings ahead of the tech wreck and the Great Recession (I wrote about this frequently as it was happening). It would be worth your time to look at a chart of the S&P 500 from both early 2000 and late 2007. The market gave several months of gradual decline to get out or reduce exposure and that is what we did.

In looking at these sorts of things and knowing we would have a few months to shift away from equities, we would start slowly maybe just selling one or two things or maybe adding an inverse fund and then continue to reduce exposure from the more volatile sectors over a period of several months as we did in 2008. It would be very unlikely that we would not go down at all but the last time around we went down a lot less than the market and we hope we can do the same the next time the market goes down a lot, whenever that is.

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