2023-03-14 10:00:00 ET
Summary
- While I am not predicting a crash, the odds of a sharp market selloff have risen greatly and one should have a plan for such an event.
- In this article, I will first discuss things you can do to prepare for a crash.
- And likely more interestingly, I will discuss how you can survive and even profit from a market crash.
- Hopefully, you will find this article educational and useful, and it also details the kind of strategies we implement at our Seeking Alpha service.
Introduction
The key to a healthy financial system is “confidence.” Perception is more important than reality. If investors lose confidence in the financial system, regardless of whether it is warranted, that is when you get the biggest market drops. These drops are generally sharp and happen much more quickly than selloffs due to a looming recession or economic slowdown. And we have started to see a bit of a loss of confidence in recent days. It doesn’t matter that some stocks may be undervalued or that these companies have strong balance sheets and are not affected much by current events. If the market sells off sharply, they will go down with everything else, just maybe to a lesser extent.
I am not predicting a crash, but the odds of one happening have gone up quite a bit. You should be prepared. So here are some things you can do to prepare for a possible crash as well as what you want to do during a market crash.
Preparing For A Possible Crash
- First thing I would recommend is that anyone with open “good til cancelled” buy orders cancel those today. If those orders get filled, you will probably be sorry as the prices will likely close at lower prices than you paid.
- As a preemptive move, you might want to exit your least favorite positions and increase your cash in preparation for a possible crash. Since cash is paying a nice yield now, the cost should not be that much to do some portfolio de-risking. Having more cash in a crash can be very useful, and of course shrinking your portfolio will help to minimize your losses.
- Have a margin account. You need to be able to short securities, particularly ETFs. If you have a cash account, convert it to a margin account even if you end up never shorting anything. A margin account also lets you execute pair trades which can really work well in a sharply declining market where mis-pricings can be huge. Even in a normal market, pair trades can be very profitable.
- Consider shorting some iShares Preferred and Income Securities ETF (PFF) or relatively overvalued fixed-income securities as insurance now. Insurance is not free, as it may lower your gains if the market rallies, but fewer gains is far better than big losses. And PFF is cheap to short in terms of having low borrow fees and it is a portfolio that simply follows an index and will not take advantage of mis-pricings. In other words, PFF will perform very poorly relative to the actively managed portfolios that we recommend to our subscribers. This will be especially true during a crash when opportunities abound and PFF will not be able to take advantage of these opportunities.
What To Do During A Market Crash
1) Because preferred stocks and baby bonds are illiquid, it is very difficult to sell them in a crashing market. When the COVID crash was occurring, there were very few bids. If you had 100 shares of something, you could probably sell them, but if you had 1000 shares and the last trade was $23.00, you would likely see a bid for 100 shares at $22.00, 200 shares bid at $21.00 and 300 shares bid at $20.00 and nothing else. Thus, the only way to lighten up your risk is by shorting overvalued securities that haven’t broken down yet or shorting an ETF like PFF.
2) You will likely see bargains during a panic as investors are just selling anything at whatever price. The pricing in the market will not make any sense. This is a great opportunity. Illiquid securities often trade down to ridiculously low prices as we saw during the COVID meltdown. Baby bonds and preferred stocks sometimes even sell off more than common stock of the same company which is absurd given that the common stock has more risk. These pricing anomalies offer great opportunity. Market meltdowns offer big opportunities for making swaps; selling your relatively overvalued securities while buying undervalued securities.
At our Conservative Income Portfolio service, we are highly focused on mis-pricings and profitable swaps. We do not subscribe to buy and hold, which has been a miserable philosophy in this bear market and will perform even worse in a market crash. We believe in opportunistic and active investing and guide our subscribers accordingly.
3) If you see something you want to buy during a crash, do so, but offset it by selling something else in your portfolio that has held up better or is less undervalued. You don’t want to increase your market exposure during a crash. The big money is made after the crash is over and the market is rising. You don’t have to pick the exact bottom to make money after the crash. Don’t be a hero. If a preferred stock goes to $12.00 during a selloff, you can still make a ton of money on it by picking it up at $13 or $14 after the market has stabilized.
An option to selling one of your positions in order to buy another is to short an overvalued security rather than selling one of yours. Another option is to short the PFF ETF which is very liquid and easy to short. Also the borrow fee on PFF is quite low; likely lower than shorting a relatively overvalued preferred stock. If you make good swaps during a crash, you should come out of a crash with a portfolio with huge upside and a very high yield. Periods following a crash are where fortunes are made and that all begins with positioning yourself correctly during a crash.
4) In a crash, not all securities break down at the same time. Some are delayed. You should look for some of those to short as they will almost certainly break down and once they do they will fall a lot in price.
Real Examples of What To Do During A Crash
Having been an investor for a very long time, I have experienced a number of crashes and mini crashes from the 1987 crash to the .com bust, from the great financial crisis of 2008 to the taper tantrum in 2013, from the 2016 and 2018 mini crashes to the COVID crash of 2020.
I remember in 2008 that I had a position in Public Storage ( PSA ) preferred stocks. They had traded down to around $18.00 during the crash but they had a junior preferred that was still trading near $25. So I shorted a lot of that and it eventually broke lower down to $18.00 and I recouped all of my losses on my PSA preferred positions. Unfortunately, I don’t have a chart to show since this junior preferred was called a long time ago.
Another one that I remember well I do have a chart on. That was Entertainment Properties, preferred stock symbol EPR-E back in 2008.
Price Chart From October 2008
As you can see, EPR.PE dropped about 16% in just a day or 2 around October 10 th . But I also noticed that at the same time EPR common spiked up by 9%. Thus, I shorted a lot of EPR common stock which quickly broke down. Below is the same chart but with prices rather than percentages on the Y axis.
As you can see, I had owned EPR-E ( EPR.PE ) at around $24.00. By October 27 th it had fallen to $16.98 for an approximate $7.00 loss. But my short of EPR, which was done at price of around $48 dropped to $29.51 during the same period for a gain of around $18.50 per share. So by actively managing my account, and looking for mis-pricings and anomalies, a big loss was turned into a big gain. I am most proud of my trading in 2008 because I actually had a profit that year when most investors took a 40 to 50% loss.
Final Comments
As I stated above, I am not a believer in a buy and hold strategy but a believer in an opportunistic and actively managed strategy that is focused on mis-pricings. It is this strategy that we use at our Conservative Income Portfolio service where we follow all sectors of fixed income. I believe it is important to follow a wide range of fixed-income securities in order to find the best values.
Market crashes do not have to be a disaster. In fact, my best year as an investor/trader was 2009, as I was able to position myself for huge capital gains as a result of the crash. You should always have a plan for what you will do in a market crash before one hits. I believe the above suggestions should be very helpful in preparing for a crash as well as making the best out of a crash.
Although I have no idea whether a crash is coming soon, I feel safe in predicting that there will be a crash again sometime in the future :-). I hope you found this article educational and useful.
For further details see:
Strategies To Survive And Profit From A Market Crash