The next stock market crash is coming sooner than you expect. Here's how to prepare.
The sky is falling for investors and the stock market just had its worst three days of the year. A recession warning signal with a perfect track record just flashed red but most investors are nowhere near prepared for what’s to come.
In this video, I’ll show you why a 2020 recession is more likely than investors realize and what you need to do to get ready for the next stock market crash.
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What is the Market Saying about a Stock Market Crash?
The sky is falling ladies and gentlemen! The worst three days of the year for the S&P 500 have all been in August and seven of the worst 10 days have been since May.
In fact, the market has gone from a roaring 21% gain on the year to a daily roller-coaster that would make 7 Flags jealous.
Economists are currently putting the chance of a recession in the next year at 35%…but then again, economists have a lousy track record of predicting recessions.
Research by Fathom Consulting found that of the 469 recessions since 1988, the International Monetary Fund has only been able to predict four by the spring of the preceding year. Worse still for investors, the IMF has never forecast a recession in a developed country with a lead of more than a few months.
Private-sector economists aren’t much better. Another study by Zidong and Loungani found that private-sector economists have only correctly forecast five of the 153 recessions in 63 countries from 1992 to 2014.
So if you’re waiting on economic models to tell you if a recession is coming in 2020, good luck with that…and this is from a guy that has worked as an economist!
Warning Signs for a 2020 Stock Market Crash
But there are some very strong warning signs pointing to an eventual recession and the coming stock market crash. So what I want to do in this video is start by listing out the reasons we could see a 2020 recession, what you can do to prepare and how to invest before a recession.
Now ten years outside of a recession, I know it can sound like a pointless economic term, something only academics worry about. But just take a little time to remember that last 2008 recession.
We all remember the 50% drop in stocks but don’t forget that 2.6 million people lost their jobs as well. Tens of thousands of people ready to retire saw their nest eggs wiped out, and the National Institute of Health found nearly 10,000 cases of suicide tied to the crisis with thousands in the U.S. alone.
This is serious and one of the most powerful recession warning signs went off this summer.
The interest rate on the two-year government Treasury bond has been higher than the rate on the 10-year government bond several times. Normal is for the longer-term bond to yield a higher interest rate, investors should want a higher rate for locking up their money for ten years instead of just two.
Why this is important is because that yield curve inversion, as it’s called, has signaled every recession in the last 50 years.
While a lot of other recession warning signs might flash off-and-on but without a great record for actually predicting a recession, this one has a perfect record, every single time.
A recession has followed the inverted yield curve by an average of 22 months, which would put the start of a recession in mid-2021. That’s just the average though and there have been three recessions in the last 50 years that started much sooner after an inverted curve.
Looking at the stock market now, which usually dips well before an actual recession. For example, the stock market started falling in July 2007, a year before unemployment really started getting bad in 2008. Here we see a scarier picture for 2020. In three of the five recessions since 1980, stocks started falling from their peak almost a year before the recession started.
That means we could see stocks start getting slammed mid-2020 or even earlier.
There are other warning signs to a coming recession but the real risk is that all this becomes something of a self-fulfilling prophecy. The market is reacting to the inverted curve, selling off like a recession is coming. Companies see the stock market falling and start to rethink their hiring plans for the rest of the year. That causes unemployment to start rising which decreases consumer spending and pretty soon…we’re deep in a recession.
How to Prepare Your Investments for a Recession
So for those of you dedicated enough to sit through the econo-speak there, and you know I never like to just go straight into what to do without explaining why first, let’s look at how you can prepare ahead of that stock market crash.
And here I want to cover a few ideas, not only to prepare you financially but also how to invest ahead of a recession.
First, it’s time to look at your income and expenses and take an honest look at the possibility of not being able to cover your bills.
The unemployment rate hit 10% in 2009 with over 15 million people out of work. Worse still was the fact that average time unemployed reached 40 weeks, three years unemployed for many people and more than twice the average we had ever seen before.
So I want you to attack this from both sides, your income and your expenses. Maybe this isn’t the time to buy that shiny new car or to be taking on new bills but it is the time to start looking at ways to make a little extra cash.
Whether that means putting in a few extra hours at work or just starting a work from home hustle on five or ten hours a week, this is going to give you that extra cushion to survive anything a recession brings.
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Rebalancing Investments Before a Recession
Investing before a stock market crash or recession doesn’t mean you have to time the market perfectly. After more than a decade of higher stock prices, now is the perfect time to rebalance your portfolio to take some risk out of stocks and find protection in other assets.
What I mean by rebalancing is looking at the amount of money you have in stocks, bonds and real estate compared to your total portfolio. For example, if you have a total portfolio of $50,000 with $45,000 in stocks and $5,000 in bonds, then you have 90% of your money in stocks and just 10% in bonds (and subsequently, nothing in real estate).
The reason this is important is because having too much in stocks just before a recession or market crash is obviously not a good thing. Millions of 50-something investors had almost everything in stocks when the market crashed in 2008, losing half their retirement savings.
Having money spread more evenly between stocks, bonds and real estate will protect you from the worst of a coming crash. You’ll still see your stock portfolio fall but your overall portfolio value will be protected by the other two investment types.
So here you’re going to add up all your investments in stocks, bonds and real estate. That means adding up all the individual stocks and stock funds, adding up the bond funds and adding up any investment in REITs and direct property investments.
Then you take each of these three numbers and just divide by the total to give you a percentage you have in each asset. If you have that $50,000 total invested with $30,000 in stocks, $15,000 in bonds and $5,000 in real estate investment trusts, then you’ve got thirty grand divided by fifty or 60% in stocks. You’d have 30% in bonds and 10% in real estate.
And that’s actually not a bad percentage split though I’d have a little more in real estate and less in bonds. Now the target percentages you want will depend on your age and tolerance for risk but I can almost guarantee you, nine-in-ten people watching this video are going to have more than 80% of their money in stocks and that’s way too much if you’re looking down the barrel of a recession.
Best Stock Sectors Before a Recession
Another strategy to use before the coming recession might be repositioning into sectors that are not as expensive as the overall market. The chart here shows the forward price-to-earnings ratio of each sector of the economy. That’s the price of the stocks in the sector divided by the combined earnings analysts think the companies will report over the next year.
You see here that the S&P 500 market index is trading at a price of 16.2-times expected earnings of the companies in the index. That’s a premium of almost 13% over the ten-year average at 14.8-times forward earnings. Some of the individual sectors are even more expensive with stocks in Information Technology trading for a 29% premium on their ten-year average.
But there are pockets of value still in the market with stocks of financial companies and energy companies trading below their long-term valuations. This isn’t to say that all financial or energy companies are good investments but there certainly does seem to be more value opportunities compared to the more expensive sectors.
You can take this information and invest broadly across the value sectors, investing in funds like the Financials Select Sector Fund or look for best-of-breed companies within these sectors.
You can also rebalance your portfolio to some of the traditionally-safe sectors and into cash before the recession. Research by Fidelity shows the average returns of sectors during a recession as well as how often the sectors produced a positive return.
Of the 11 sectors studied, five have produced positive returns during recessions with three of those sectors; Consumer Staples, Utilities, and Health Care all generating positive returns in 70% or more of the recessions studied. Compare that against a sector like technology, which we already know is expensive on a PE basis, that has averaged a negative 8% return during recessions.
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Stress-Free Investing Before a Stock Market Crash
This strategy might still be a little more market timing than a lot of you want…and there’s nothing wrong with that at all. The vast majority of investors would do very well to invest in a diversified portfolio, make regular deposits and take a stress-free approach. I’m talking about just investing in a handful of funds and stocks, not trying to change your investments in different sectors but just hanging on for the long-run.
You still need to watch the amount of money you have in stocks, bonds and real estate though. After more than ten years of a bull market, most investors have way more in stocks than is safe.
For example, if you had a 50/50 portfolio of stocks and bonds in March 2009, you would now have over 75% of your portfolio invested in stocks. Stocks have returned an annualized 17% return while bonds have lagged with a 4.% return over the period.
Having more money in stocks over the last ten years has certainly paid off but now it leaves you hugely exposed to a stock market crash. If we get another crash like the 2009 disaster and stocks lose half their value, your nest egg is going to fall off a cliff.
So even if you don’t want to use some of the strategies here, repositioning in different stock sectors, you still need to rebalance back to your target percentages in stocks, bonds and real estate. I'd say that's the minimum you need to do before a recession or stock market crash. It might not save you from losing something during a crash but it will protect much of your portfolio and get you ready to take advantage of the rebound.