Is another stock market crash coming?

After months of positive recovery, the market seems to be slowing down again. Are we getting closer to another stock market crash?

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There is no doubt that this question is on our minds right now. After a few great months of recovery following the March stock market crash, things seem to be slowing down.

The S&P/ASX 200 Index (ASX: XJO) has tried and failed multiple times to make it higher than 6,200 points. Before the March correction, the index rose as high as 7,200 points. Even with the recent strong rally following those lows of around 4,400 points in March, we are still sitting low. In fact, we are still a full 1,000 points or more below this previous high. 

One thing to note here is the unique complexity that coronavirus has brought with it. We have never seen a crash exactly like this one. Although stock market crash events tend to have some similarities, each one is absolutely unique.

We are seeing a huge amount of stimulus from our governments and even the most experienced investors are struggling to come to a consensus on market direction. Keep this in mind when trying to 'predict' the market.

Everyone has an opinion, however I believe the best thing for investors to do is simply be prepared for all possibilities. 

Things to consider

The S&P/ASX 200 Index

The Index is not a single company. The ASX 200 is made up of the top 200 companies listed on the Australian Securities Exchange, by float-adjusted market capitalisation. So when you are looking at the 'ASX 200' falling or climbing, just remember that this doesn't mean individual shares will rise or fall.

Small cap shares for instance, may not move with the ASX 200. The media often refers to the market falling or rising by a number of points. This is generally related to the ASX 200 Index.

Understanding what the index means will allow you to make more informed decisions.

The 6,200 point barrier

Now we have discussed the ASX 200 makeup, we can look at the points again. While the top 200 companies represent less than 10% of companies listed, they are certainly very important. With this in mind, we come back to the 6,200 point barrier.

The index has made five attempts to break through this barrier between 9 June and 25 August. It's interesting because if we apply the same logic to an index that we do to a share price, multiple rejection is never good. Its shows a lack of strength and an inability to gain ground.

To me, breaking above this 6,200 point level is critical for positive change. 

Compounding this doubt is the fact that for the last 2 weeks, the index has been steadily trending down and away from that barrier, in retreat.

Business and life is evolving

The world is changing and evolving. What we know today, may not apply tomorrow. We are seeing changes in the way people work, the way companies operate and the way we live our lives. We are in the midst of a digital evolution and it's affecting the whole planet.

It's hard to imagine but, whilst we are seeing certain industries struck down by the pandemic, such as airlines, others, like technology providers are thriving. It's a shift and a flow of both money and energy. Although we see increasing unemployment among traditional jobs, at the same time, there are also many technology companies advertising for multiple roles to handle the new workload. It's a changing game.

On another note, this changing landscape is adjusting what we think we know about the financial health of companies. For example, recently Premier Investments Limited (ASX: PMV) announced that sales were down 18% globally.

Normally, this would be a shocking piece of news for investors, however the Premier share price rose 12%. The reason for this was that although sales were down, net profit was actually up. As most of the brands in Premier's portfolio are retailers, the physical shops have had to close for lock downs. However, online sales have surged, accounting for more than quarter of total sales. 

It's a different game.

The reality of share prices

We regularly see the financial media comment on the over or under valued nature of share prices all the time. Every analyst has an opinion and a methodology for valuing a company – myself included. However, there is one very important thing to remember: A company is not its share price.

We might see prices crash, but remember that the company could very well still be trading normally. You could see prices surging and when you look at the company, you find it's not even making a profit.

If a company is surging with no profit, is it 'overvalued'? Perhaps, however I would also argue that if two people, a buyer and a seller, agree on a price, then that company may not be over or undervalued. It may just be 'valued' correctly at the time of trade.

It's an interesting question and I'm not taking anything away from true valuations or fundamental analysis. In fact, I trust and rely on fundamentals myself, however it's worthwhile being aware of the reality of a real-time market, like the ASX. The share price is what a buyer is willing to pay, at the time.

How to handle a potential stock market crash

Have a plan

The first thing to think about is who you are as an investor. A financial advisor may be the best person to help you personally understand your goals and objectives. Having clarity around your goals will allow you operate with a clear mind in a crisis.

Some investors will lose sleep at night if they see shares in their portfolio falling in value. If this is you, have a plan. Know what you are going to do ahead of time. Know what you are happy holding and what you would prefer to sell. It's important to think about your portfolio and positions ahead of time. It's also important to know how to log into your trading account!

Long-term investors tend to view short-term corrections as nothing more than a blip on the radar. If this is you, a potential crash may not faze you too much. However, you can always improve your position. One strategy you might consider is dollar cost averaging. This involves keeping a supply of cash available to purchase more shares at lower prices later, should you need to.

Another reason for a long-term investor to keep some spare cash around is to be able to take advantage of buying opportunities quickly. In the March crash, investors had a matter of days at the bottom of the market. It's worth being prepared to act.

Risk management is key

Having a risk management mindset is a great way to operate in a stock market crash. Be aware of the risks involved in your positions and understand the potential losses. Even if you're not an analyst, you can refer to past events to understand the risks of your holdings.

One thing you can do right away is check out how low the prices went in March this year for all your holdings. In the event of another crash, it's likely the market could revisit previous levels and even lower. Having a look at previous prices can help you to understand the potential impact.

For example, Afterpay Ltd (ASX: APT) fell from over $40 to $8.90 in the March market crash, losing approximately 80% of its value. If that were to happen again at today's value of around $73 per share, an 80% drop would mean prices could dip below $15 per share. This is not a prediction, it's just basic risk management. If a major crash occurs, we can expect companies which were heavily impacted previously to be significantly impacted again.

If you consider risk management ahead of time, you will be able to consider the possibilities and make less emotional decisions. It's certainly helpful to think about.

Look at ways to hedge your portfolio

Selling shares at the first sign of a correction isn't always the best default move. Apart from the disruption to the portfolio you have worked so hard to build, there is also the tax implications to consider. This is something to discuss with your tax agent to really understand the repercussions of transactions. 

One possibility you have to help prepare for a market crash, aside from keeping spare cash for further investment, is to add hedging to you portfolio.

Companies showing resilience

One example of hedging is to purchase more companies that stand up well during a stock market crash. For example, large grocery companies such as Coles Group Ltd (ASX: COL) fell less than 20% in the March crash (compared to 80% with Afterpay). Another example is technology provider and artificial intelligence leader Appen Ltd (ASX: APX). Appen fell around 40% in March, however bounced back quickly and has gone on  exceed all previous highs. Lastly, healthcare giant CSL Limited (ASX: CSL) fell a mere 25% in March while most of the ASX was bleeding. It has held ground well since then. 

Negative correlation exchange traded funds

In a previous article, I wrote about three exchange-trade funds (ETFs) you can use to hedge your portfolio in a downturn. The purpose of a negative correlation ETF is to inversely track the direction of a regular index, such as the ASX 200.

For example, BetaShares Australian Equities Bear Hedge Fund (ASX: BEAR), which aims to produce returns that are negatively correlated to the returns of the ASX 200. If the ASX 200 moves -1%, BEAR can be expected to be positive +1%. As you can imagine, putting some extra cash into this ETF can help to offset the paper losses on the main portfolio, should you choose to hold your shares in a crash.

For investors with a little less cash, or even those looking to make a little profit on the way down, you could potentially look to a negative correlation ETF that is 'magnified'. BetaShares Australian Strong Bear Hedge Fund (ASX: BBOZ) is one such fund. BBOZ aims to produce magnified returns that are negatively correlated to the returns of the ASX 200. If the ASX 200 moves -1%, BBOZ can be expected to be positive +2.4%.

Foolish takeway

Facing the prospect of another stock market crash can be a little unnerving to say the least. However, being prepared, managing risk and looking for options to hedge your portfolio can really help. 

My suggestion is this, don't try to predict the market. Instead be prepared for all scenarios. Investing is what we love, so it doesn't make sense to stop doing it. What does make sense is preparation to ensure we can continue doing what we love well into the future.

A market crash is often required to keep the market healthy. Throughout history, the market has bounced back stronger and stronger each time. You can draw confidence that we will always recover, it's just a matter of time. Having a sense of awareness and being prepared can be the difference between panic and success. 

I hope this article has helped to guide you through the prospect of a potential crash. It's not that scary if we are ready for it! 

glennleese owns shares of BetaShares Australian Equities Strong Bear Hedge Fund. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of and has recommended Premier Investments Limited. The Motley Fool Australia owns shares of AFTERPAY T FPO, Appen Ltd, and COLESGROUP DEF SET. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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