What to Do When the Stock Market Drops

History books and record books will study the first half of 2020 with intense interest. From an investor's perspective alone, we've had a number of major market events that we're still grappling with, and ongoing issues have injected huge amounts of uncertainty into the markets. A global pandemic, caused by the coronavirus, led to the brutal severity of the early spring pullback and the widening disparity between the equity and bond markets. The global economy went into free-fall; the staggering number of jobs lost in so short a time is without precedent, and many small businesses are under strain. And what happened next? A record-breaking market rebound despite a resurgence in virus cases and no vaccine as of yet.

That sharp rebound is reflected in the CNN Money Fear and Greed Index, which jumped into Greed territory compared to Neutral several weeks ago, indicative of the emotion driving the market. Times of Greed or Extreme Greed can be a precursor to more volatile times ahead, but since one data point can’t paint a full picture, it’s wise to examine a multitude of data points for confirmation.

How we got here

The most recent AAII Investor Sentiment Survey showed that compared to the bearish historical average of 30.5%, 47.6% of survey respondents were bearish as of August 5 while only 23.3% were bullish, well below the historical average of 38.0%. The discrepancy between those historical markers and their current reading likely reflect the number of potential risks investors are staring down:

• renewed economic uncertainty following the resurgence in the coronavirus in many parts of the world;
• renewed and rising geopolitical tension between the U.S. and China;
• despite the rebound in manufacturing, services and employment data, so far less than half of the jobs lost due to the pandemic have been recovered;
• extra unemployment benefits expired at the end of July and Washington has not yet agreed on next round of economic stimulus (as of this writing);
• the Census Bureau’s latest Household Pulse Survey revealed an estimated 27% of adults in the U.S. missed their rent or mortgage payment for July while 34% said they had little to no confidence that they could make their August rent payment. That’s not exactly a confirming data point of a consumer that is looking to spend.

While the consensus view is that the U.S. economy will snap back after the June quarter’s initial estimate of a 32.9% contraction in GDP, we are already seeing downward adjustments to the September quarter GDP expectations. Following the initial batch of July economic data, the New York Fed’s Nowcast GDP forecast for September was revised lower to 14.6% from the prior 16.85% exiting July. Yet, the S&P 500 is just over 1% away from its record high even though EPS expectations for the S&P 500 group of companies calls for all of 1.6% growth over the 2019-2021 period per data compiled by FactSet.

What to do next

Given these circumstances, it’s understandable that investors are concerned over the stock market’s next move, especially since there is a big difference between paper profits and ones that have been locked in your trading account by selling shares. In our book, Cocktail Investing: Distilling Everyday Noise Into Clear Investing Signals, we discuss when to either take some stock chips off the table or close out the position entirely. When considering what to do, two items stand out: an investor’s time horizon and their risk tolerance. Generally speaking the shorter and lower they are, the more inclined they are to take profits earlier than those whose preferences are longer and higher.

But there are times when equity valuations are stretched amidst low-to-no earnings growth and the risk profile of the stock market is rising, if not already high. In those instances, there are steps investors can take to protect their portfolios.

The quick and easy answer would be to exit one’s stock position, but that also removes the potential upside to be had should the market continue to chug higher. Even a technically over-sold stock market can move higher, much to the amazement of fundamental analysts, particularly at times when the Federal Reserve has pledged to keep interest rates low for the foreseeable future and is an active buyer. In today’s COVID-19 world, the level of buying by central bankers around the world has made the fundamentals less significant. The more securities they buy, the more other market participants are squeezed into other options, which often pushes the prices of those other securities up, regardless of their underlying fundamentals.

A second option would be to sell a portion of your stock holdings, which would transform paper gains into real ones, while leaving some chips on the table to capture any incremental upside. That could, however, mean giving up some of those gains if the stocks you're keeping, or the market as a whole, comes under pressure.

A third option would be to add shares of an inverse stock market ETF such as ProShares Short S&P 500 ETF (SH) or ProShares Short Dow30 ETF (DOG) to help insulate your portfolio for a pullback in the larger stock market. A slightly more advanced strategy would be leveraged inverse ETFs like ProShares UltraPro Short S&P500 (SPXU) that seeks daily investment results that correspond to roughly three times the inverse of the daily performance of the S&P 500.

A note of caution: Leveraged inverse ETFs can protect one’s portfolio on the way down, but they can also weigh meaningfully on returns in a rising stock market and do not closely track their underlying indices. Carefully monitor the degree to which you expose your portfolio to those market hedging tools, particularly if you hold them for more than a few days. And for those with either greater risk tolerances or more experienced trading pedigrees, there is the use of options as a tool to protect portfolio gains.

Other strategies and tools

There are of course other strategies one can utilize, including migrating into safer haven investments. Such a strategy usually involves looking at companies whose business models are inelastic in nature, such as electric or water utilities, and are far less influenced by stock market volatility. Investors looking for such alternatives should examine a stock’s beta, which measures a stock’s volatility compared to the stock market as a whole. Generally speaking, a beta value that is less than 1.0 means the security is theoretically less volatile than the market while a beta greater than 1.0 indicates the security's price is tends to be more volatile than the market. For example, the beta for water utility American Water Works (AWK) is 0.25 and 0.34 for Duke Energy (DUK) while shares of Tesla (TSLA) and Facebook (FB) are all clustered between 1.2-1.3.

Other strategies along this vein can incorporate shifting into precious metals, either through ETF exposure or in the shares of a company whose business is closely aligned with precious metals. Using gold as an example, shares of gold miner Yamana Gold (AUY) would be one way to go, as would the gold ETF SPDR Gold Trust (GLD) that invests directly in physical gold. An alternative would be the VanEck Vector Gold Miners ETF (GDX) that is invested in 53 gold companies, which helps reduces company-specific risk.

Final thoughts

Regardless of what tools you may employ to protect your portfolio, an investor needs to identify ahead of time just how much of a loss they are willing to take for any particular security in their portfolio. Conversely, investors should also determine at what price they’d consider the security to be attractive. These levels should be regularly reviewed in light of changing conditions. Defining when to get out ahead of time will help investors not get emotional and ride their holding down further and further, unwilling to recognize the value they’ve lost. Defining at what price a security will be attractive ahead of time can help investors not miss out of buying opportunities when the market is dominated by fear.

While the phrase “This time is different” is often ridiculed, it is also true that the market is very much a living thing that is constantly evolving. For example, we’ve never before had the U.S. Federal Reserve as a major purchaser of securities. We’ve never had this level of debt issuance by the U.S. Treasury. We’ve never before had this level of corporate debt. It is always different and the level of market complexity is such that no one can really predict what is going to happen in the next three, six, or twelve months with any degree of accuracy.

Life savings are lost and poor decisions are made when emotions drive investing decisions, particularly in times of great fear or greed. What the individual investor can do is have a well-thought out plan in place and a methodical process for updating that plan as conditions change. Sticking to that plan when the markets get wobbly can save your portfolio and your sanity.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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