Is now the time to prepare for the possibility of a huge market downturn later this year? It may be.
A number of market prognosticators I’ve been reading think there is a good probability we will have a “W” shaped economic recovery. This theory suggests that the first dip in the “W” was the global stock market crash last fall, and the upward rise in the middle of the letter is the current market rise. The next phase will be another crash, equal to or deeper than what we saw in the fall, before we see a sustainable recovery.
I spoke about this possibility in the “Town Hall” I did for readers in April. If the 1929 – 1932 bear market is any indicator (and it’s the most comparable to the current crisis) we would now be in the middle of the bear market.
Bob Veres of Inside Information reported on a speech given last month by Roger Gibson, author of Asset 
Allocation. While he said it’s not improbable that the next ten years will give us annualized double-digit returns, we may not have reached the bottom of the current bear market. Gibson’s concern, which also parallels the thinking of investment advisor Lou Stanasolovich, is that the deepest recessions have seen P/E (price/earnings) ratios hit 7 to 9. So far, our lowest P/E ratio was about 11 and stands currently at 15.5. To reach a P/E ratio of 9, the market would need to fall 43%. That would put the Dow Jones Industrial average at about 4,900.
Before you jump out of your first story window, let’s put this in perspective. First, almost no one saw the first crash coming. A bunch of people are seeing the second crash coming, which could be the best insurance that it won’t happen.
Of course, I do remember writing an article in 2004 about all the stories proclaiming we were in a real estate bubble which would prove to be as nasty as the dot.com bubble. I pooh-poohed that by saying no one saw the dot.com bubble coming, so all the predictions of a similar bubble in real estate were probably our best insurance there would be none.
Okay, maybe you should jump.
Before you do, though, there may be a better course of action to prepare for the possibility of another nasty down leg of this bear market. If you are retired and you’ve followed my advice and stayed in the market, this could be a good time to raise some cash. You may want to consider selling off enough assets to fund two to three years of withdrawals. This should get most portfolios through the worst of a downturn without having to liquidate at a market bottom to raise cash.
This is also time to make sure your portfolio is diversified in at least five asset classes. If your portfolio is mostly in U. S. stocks and bonds, you may want to consider moving at least half of it into additional asset classes like commodities, real estate investment trusts, absolute return strategies, treasury inflation protected securities, and international stocks and bonds. By my estimates, investors with a broad array of these asset classes lost up to 50% less in the recent downturn than those who held mostly U. S. stocks and bonds.
If you raise a little cash and diversify, the worst outcome is that you give up a point or two of return over the next two years. And if the worst happens, you may have bought yourself some peace of mind and the staying power to be “in the game” when the actual recovery comes.
