As the old saying goes, what goes up must come down. The stock market tends to bounce higher and higher over time because of the compounding nature of earnings growth. But that doesn’t mean there aren’t painful pullbacks along the way. It’s simply inevitable that this bull we’ve been enjoying for so long will at some point turn into a bear.
While there’s no way to confidently predict when a bull market will end, there are some typical signs that it’s reaching later stages. Historically, an inverted yield curve can be a fairly reliable predictor of recessions and declining stock prices, but the timing has varied and isn’t precise. This particular indicator might not be so relevant for today’s market because current interest rates are only in the 2 percent to 3 percent range — in previous instances, they’ve been at 5 percent or greater. Plus, the yield curve is flattish at the moment, not inverted.
Many investors have begun to expect double-digit annual market gains, and this type of complacency tinged with greed tends to be self-correcting. Valuations have risen in concert with inflated expectations. High price-to-earnings (PE) ratios and other standard valuation metrics are not indicators of a bear market or even negative returns, but they do tend to correlate with lower five-year forward returns.
The PE ratio of the S&P 500 last year before the tax cut had risen to levels last seen toward the end of the dot-com bubble from 1998 to 2001 — a bubble that ended up resulting in a 50 percent correction that some investors couldn’t recover from.
However, rather than a signal of the end of days, a bear market is merely part of a cyclical process that reflects market conditions. Instead of trying to predict a bull or bear market before it arrives, we advise investors to implement a strategy that is successful over full market cycles. Going through the following steps with an advisor can help safeguard against significant stock market corrections:
1. Assess Risk Tolerance
It’s easy for investors to think aggressively during a long bull market. However, because all good things must come to an end, think long, hard, and honestly about the risks you’re willing to take and the losses you can withstand.
In percentage terms, a simple rule is that investors should own no more than double the amount of stocks they would be willing to lose. So if a 35 percent loss would be your absolute limit, stocks should account for no more than 70 percent of your investing strategy. Losses of more than 50 percent are rare but can happen — and being too conservative and never testing the limits of your risk tolerance can actually be an even bigger long-term risk for some investors. Because percentages are more abstract, it might help to think about these figures in terms of an actual dollar amount.
2. Understand Portfolio Positioning
Asset allocation is incredibly important, but most people have no idea what theirs is — especially across multiple accounts. There are many financial tools available to help investors make sense of it. Instead of guessing where markets will go in the short term, portfolios should center around an individual’s cash flow and strategic long-term goals. Some of the most important technological advancements in portfolio management are those that help investors plan for long-term asset allocation.
3. Diversify Investments
If asset allocation is the macro view of your portfolio, diversification is the closer, more detailed look. Just like stocks could take a big loss overall, a concentrated single stock position could fall even further. It’s also a good idea to avoid investing only in certain sectors or industries — for example, during the dot-com bust, technology stocks lost a devastating 80 percent of their value. If you think that won’t happen again, consider Bitcoin’s recent 70 percent plunge.
4. Remember to Consider Taxes
Intelligent investing is about adopting a long-term perspective, and a portfolio’s performance in a bull or bear market is far less important than the outcome over many market cycles. While taxes and fees might not change a short-term investment strategy, over an extended period, they can have a big impact on how quickly your assets appreciate. Investing with an eye on minimizing tax burdens might grow wealth faster and in a shorter period of time.
A bull market can’t last forever, and astute investors know that a bear market presents its own opportunities as well. For certain portfolios, however, the transition can create some emotional turbulence. The good news is that it’s possible to prepare for the coming market swing so that it positions you for the next one (and the next one).
A good place to start is to assess your long-term risk tolerance independent of fluctuating market conditions. Then, position your portfolio to reflect your risk preference, and diversify individual investments to protect you from cyclical changes. Finally, accurately weigh the burdens imposed by taxes and fees to ensure your investments are as productive as possible and you’re able to leave them alone so they can appreciate to their fullest potential.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.