Smart Investor's Guide to Preparing for a Down Market

What's the best way to invest when the market is going down? Certain stocks, bonds, and mutual funds do better when the market isn't doing well. You don't have to wait for official announcements to know when the market is struggling; it's smart to start getting ready before it happens.

Discover more about bear markets and how you can make the most of them by investing wisely before and during these times.

What Is Bear Market?

A market correction occurs when prices drop between 10% and 19%, while a bear market happens when prices fall by 20% or more. Since 1974, there have been 22 market corrections and only four bear markets.

The duration of a bear market refers to how long the decline lasts. Historically, bear markets have lasted from about three months to over three years. Among the recognized bear markets, their durations were typically longer than one year but less than two years.

Is There a Bear on the Horizon?

A bear market doesn't have a clear starting point. Usually, a bear market follows a market correction, but not every correction turns into a bear market. Investors get anxious when the market corrects because they worry about potential losses from a bear market.

This nervousness often leads to people trying to predict the market's movements. However, it's not a good idea. Bear markets typically happen after periods of rising prices when investors are overly confident. This confidence is similar to what gamblers feel during speculative bubbles, when prices rise due to speculation.

What Investments Work in Bear Markets?

One way to invest during a bear market is to purchase stocks at lower prices, but it's important to be careful. When buying stocks during this time, focus on companies that have a history of surviving economic downturns.

Experienced investors often recommend investing in "staple stocks." These aren't just related to toothpaste companies. They refer to stocks from companies that produce everyday essential items like toothpaste or other basic necessities that people will always need. These companies tend to be more stable during challenging economic periods.

If you've wisely chosen investment tools like a 401(k) or index funds, it's beneficial to keep contributing. Although their overall value might decrease during the market downturn, buying more at lower prices can be advantageous. When the market eventually rebounds, these purchases made during the decline will grow in value as prices rise in the upturn.

During a bear market, assets like bonds and precious metals could be beneficial. They've historically performed well when stock prices and interest rates are falling.

Bear Markets and the Federal Reserve

No one can precisely predict when a bear market will start. However, a hint that a bear market might be approaching is when the Federal Reserve (the Fed) starts increasing interest rates after lowering them.

Rising rates by the Fed indicate a healthy and mature economy. Typically, this occurs towards the end of a growth cycle. In simpler terms, it happens near the conclusion of a bull market, signaling the approach of a bear market.

This means that when the Federal Reserve lowers or maintains low interest rates, it's usually a good idea for investors to keep their investments. Lower rates make it cheaper for companies to borrow money, which often leads to increased profits. They might use the borrowed money to invest in technology or to refinance debts at lower rates. This often happens around the peak of a bull market.

A bull market tends to peak before the economy does. This is because the stock market predicts and reacts to future conditions. It's like a "preview" or a "sign" of what's to come. The stock market usually starts declining before it's officially announced that the economy is in a recession.

In simpler terms, stock prices today show what investors think will happen soon. Meanwhile, economists and the Fed look at past events to understand how the economy is doing right now.

How Can You Use the S&P 500 P/E Ratio as an Indicator?

An index acts like a yardstick for certain assets. The S&P 500 Index measures the performance of the top 500 stocks in the market, according to S&P's assessment. The price to earnings ratio (P/E) is a way to judge how much stocks listed on this index are worth at any given time.

Using the P/E ratio to guess short-term stock market changes might not always be accurate. But it helps generally to figure out if stocks are priced high or low.

Understanding the overall value of stocks by looking at the P/E ratio on the S&P 500 can give you an idea of what investors think about stocks. This might hint at where stock prices could go in the future. When stocks seem too expensive, investors might start selling in a rush to prevent losses. This could lead to a market correction or a bear market, or sometimes just a small drop in prices.

The P/E ratio of the S&P 500 Index isn't straightforward. To determine this ratio, you need to check each stock listed on the index and find its individual ratio. You can calculate it yourself or search for pre-calculated results online.

If you discover that your stocks have lower P/E ratios compared to those in the S&P 500, you might consider lowering risk in your investment portfolio. One way to do this is by reducing your stock holdings.

What Is Tactical Asset Allocation?

The way you divide your investments among different types of assets, known as asset allocation, has the biggest impact on how well your overall portfolio performs. Over long periods, this factor matters more than picking specific investments.

For instance, let's consider tactical asset allocation. If you notice signs like high P/E ratios and increasing interest rates indicating a market shift from a bull to a bear market, you might want to adjust your investment strategy. You could decrease your exposure to riskier stocks and increase your investments in safer options like bond funds and money market funds. This shift in allocation can help manage risk during market changes.

Let's say your usual mix for investments is 65% in stocks, 30% in bonds, and 5% in cash or money market funds. But if you notice high P/E ratios, record-breaking market levels, and increasing interest rates, you might want to lower your risk. So, you could change your investment mix to 50% stocks, 30% bonds, and 20% cash to balance things out and reduce risks.

Bear markets for stocks typically last around one year on average. However, by the time it's officially announced that the economy is in a recession, the market might have already been going down for three or four months. If the market downturn doesn't last as long as usual, the worst might already be over by the time everyone hears about the recession.

Prepare For Different Markets

Consider preparing your investment plan before a bear or bull market starts instead of waiting for it to be confirmed. Build a diverse portfolio, strategically manage your assets, be ready to adjust small parts of your investments, and pay attention to market signs. These approaches can help your portfolio perform well during market shifts and prevent you from reacting impulsively like other investors when the market turns.