“The biggest ever single-day price rises on Wall Street came during the bear markets.”
President Trump said, during an election rally in October last year that, “we’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down. We are in a big, fat, ugly bubble. And we better be awfully careful.”
At the time the Dow Jones Industry reached 18,000 points and since then has climbed to 22,000, climbing in an almost linear fashion from 7,384 points at the depth of the financial crisis in 2009.
What can past market crashes teach us about the current one?
The markets have largely recovered since the March selloff, but most would agree we're not out of the woods yet. The COVID-19 pandemic isn't close to being over, so it seems that volatility is here to stay, at least until the pandemic becomes less severe. Q2 2020 hedge fund letters, conferences and more At the Read More
Trump further added that “the day Obama goes off, and he leaves and goes out to the golf course for the rest of his life to play golf when they raise interest rates, you’re going to see some very bad things happen.”
Trump was essentially claiming that a stock market crash was going to occur sometime soon after the U.S. Presidential inauguration.
We know it didn’t happen and the Dow climbed another 4,000 points in that time.
Now, with the news that North Korea has successfully tested an H-Bomb, causing the Dow to drop 200 points, raising the real possibility of military action, could military action be the straw that breaks the camel’s back?
Or could a market sell off of Bitcoin be the catalyst for a stock market crash?
Warren Buffett’s Berkshire Hathaway is currently holding $100 billion in cash, a position he prefers not to have but he hasn’t found suitable investment opportunities to deploy the cash. Perhaps a signal that the market is getting frothy, he is certainly well positioned to strike if a correction occurs.
And this is going to be our main point of focus, how you can prepare right now to take advantage of a stock market crash.
In the late summer and fall of 1857, the U.S. entered its worst economic downturn in twenty years. In this cartoon, a politician grabs the reins of the economic panic of 1857, in the guise of a rearing horse. The frightened creature has already bucked a bank director, who sprawls on the ground amidst damaged mercantile goods and warns the politician of the dangers in trying to halt the panic.
The subsequent discovery of gold in California encouraged land speculation and railroad construction and made the United States a net exporter of gold.
Railroads were the backbone of the economic growth, with the construction of over 20,000 miles of track during the 1850s. They were aided by state land grants and financed by government bonds, stock sales on Wall Street, and foreign, particularly British, investments.
Cleveland, Ohio was particularly hard hit, but there was a young man at the age of eighteen, who at sixteen had just started his first job as a book-keeper and aspiring investor, was a small-time financier in Cleveland.
When the financial crisis gripped Cleveland this young man would later remark in old age, ‘Oh, how blessed young men are who have to struggle for a foundation and beginning in life, I shall never cease to be grateful for the three and half years of apprenticeship and the difficulties to be overcome, all along the way.’
What lessons did this young man learn during those three and half years of apprenticeship and the difficulties he encountered?
We know now that the lessons learnt by the young man would later help him become one of the World’s richest men in history.
His name was John D. Rockefeller.
How do you keep your head when others around you are losing theirs?
If we are going rise to the occasion and seize the moment during a market crash one first needs to condition their mind.
You could have the best investment tools and insights at your disposal, but if you cannot control your own emotions, they are useless.
The Stoics – Marcus Aurelius, Epictetus, and Seneca – have provided us with the mental framework to apply not only during times of extreme pessimism when emotions are running high during market crashes but also for everyday occurrences.
“Don’t let the force of an impression when it first hit you knock you off your feet: just say hold on a moment; let me see who you are and what you represent. Let me put you to the test.”
As Epictetus recommends, challenge first impressions. News will spread fast, news reports will sound alarm bells striking fear into investors.
So say to yourself, just say hold on a moment; let me see who you are and what you represent?
Is it not just people selling out of fear, representing a great opportunity to build your wealth?
Expect the expected.
“Nothing happens to the wise man against his expectation,” he wrote to a friend. “. . . nor do all things turn out for him as he wished but as he reckoned—and above all he reckoned that something could block his plans.”
If you are finding less and less opportunities to invest in the share market due to rising share prices, you’d start expecting that with limited opportunities and share prices on average rising faster than the historical average, the market must be fully valued and you can expect a market correction to occur in the near future. Either in the form of small market correction or at the extreme a share market crash falling 40 percent.
Now, when the market correction – in what every form it presents itself – occurs will you be surprised? Probably not, only to the degree, it occurs at.
A positive by product of setting realistic expectations is that it helps regulate our emotions.
“Regulating your negative emotions is critical to peak performance.”
– Hans Hagemann (Co-author: The Leading Brain: Powerful Science-Based Strategies for Achieving Peak Performance.)
Actionable steps you can put into practice right now.
What is the nature of the stock market?
If you intend to engage in any activity, remind yourself what the nature of the activity is. If you are going to bathe, imagine yourself what happens in baths: the splashing of water, the crowding, the scolding, the stealing. And like that, you will more steadily engage in the activity if you frankly say ‘I want to bathe and want to hold my will in accordance with nature’. And do the same for every activity. So, if any impediment arises in bathing, readily say ‘I did not only want this, but I also wanted to hold my will in accordance with nature; and I will not hold it like that if I am annoyed about what happens’.
Epictetus, The Enchiridion
How did a small number of investors see through the carnage and spot great opportunities to enter the market in 1929 and 1987, while everyone else was tripping over each other to get out?
Stephen Vines explains why in his book, Market Panic: Wild Gyrations, Risks and Opportunities in Stock Markets, this is because markets are splendidly schizophrenic in being both rational and deeply irrational.
They are rational in their extreme response to events and new information and rational in the sense that the extreme responses do not last, allowing profits to be made by those who have not been swayed by panicky responses.
Men are disturbed, not by things, but by the principles and notions which they form concerning things. Death, for instance, is not terrible, else it would have appeared so to Socrates. But the terror consists in our notion of death that it is terrible. When therefore we are hindered, or disturbed, or grieved, let us never attribute it to others, but to ourselves; that is, to our own principles. An uninstructed person will lay the fault of his own bad condition upon others. Someone just starting instruction will lay the fault on himself. Some who is perfectly instructed will place blame neither on others nor on himself.
Epictetus, the Enchiridion
The false notion that bear markets signify the worse time to enter the stock market and that in bull markets is where the big money is made are both wrong.
History has shown that the largest single day prices rises have occurred during bear markets, not bull markets. For instance, the two biggest single day percentage gains in the U.S stock market occurred from 1931 to 1933.
15.43 percent gain on the 15th of March, 1933 and 14.87 percent gain on 10th of June, 1931. (Source)
And we see this occurs also in Japan, on the 2nd of October 1990, the Nikkei 225 Index records its biggest one day rise of 13.20 percent. This is a mere 10 months after hitting it peak of around 38, 900 points at the end of 1989 and after the Nikkei 225 Index lost around two-thirds of its value. (Source)
Vines further explains that it is not only the rational investors entering the market at its lowest but the companies themselves listed on the market. ‘By the end of the week which started with Black Monday in 1987 more than 100 US corporations announced they would be making share repurchases’.
The management of the companies understood the value of their own companies and was willing to purchase at bargain prices their own stock.
Challenge commonly held notions, and this ties neatly with the discipline of perception.
Rockefeller learnt an important lesson during those three and half years of depression, a lesson that still applies today, that the market is inherently unpredictable and often vicious, and only the rational and disciplined mind could hope to profit from it.
Rockefeller immediately put those insights to use when a group of investors asked him to invest $500,000 dollars on their behalf. Rockefeller toured oil fields for a few days around Cleveland, but returned to the group and explained that although there was plenty of excitement among the oil fields, the activity was still too speculative to invest, and so he returned the full amount of money back to the group of investors.
“It was this intense self-discipline and objectivity that allowed Rockefeller to seize advantage from obstacle after obstacle in his life, during the Civil War, and the panics of 1873, 1907, and in 1929. As he once put it: He that inclined to see opportunity in every disaster. To that we could add: He had the strength to resist temptation or excitement, no matter how seductive, no matter the situation.” Ryan Holiday – The Obstacle is the Way. (Bolded text my emphasis)
Shape your environment or let it shape you.
“Peak performance means that you find the environment that gets you in a position, and in a situation, where you can really perform at your best.”
Warren Buffett learnt early in his career the importance a suitable work environment and its effects on performance.
“In some places, it’s easy to lose perspective. But I think it’s very easy to keep perspective in a place like Omaha,” he said.
Buffett acknowledges that working far from Wall Street actually helped him.
“It’s very easy to think clearly here. You’re undisturbed by irrelevant factors and the noise generally of business investments,” Buffett said. “If you can’t think clearly in Omaha, you’re not going to think clearly anyplace.”
Find a quiet place to study, and align it with your peak energy periods. For me, it is early in the morning from 5am to 9am & 2pm to 6pm. Just focus on assessing one company at a time.
In summary, Hans Hagemann advises simply ‘to optimize the conditions for rational processing, find a quiet corner, minimize distractions, and concentrate on the problem, solving it logically step by step.’
Rules of thumb
- Treat email like snail mail, it shouldn’t be treated with urgency. Allocate one hour a day, no more.
- Turn off all notifications, they rob you of your limited attention.
- Align your peak energy periods with 4 hours of no distractions.
Winners anticipate, losers react
Don’t complex simplicity.
There is this temptation to take a simple highly effective investment strategy and make it complex. This includes creating multiple excel spreadsheet tabs filled with minuscule details, all based upon precarious assumptions.
The reason is simple, uncertainty creates anxiety, and the way most investors try to rid yourself of uncertainty is to create complex investment excel models, which end up creating a false sense of certainty.
A simple but highly effective strategy.
There is always the real possibility that shares prices will not revert back to the peak heights at the top of the market just before the stock market crash for several years, but to the thoughtful investor who is entering the market purchasing blue chip companies after the crash will not concern them.
This is because the thoughtful investor has entered the market at prices much lower than the average historical level. In doing so the thoughtful investor increases their chances for price gains, but more importantly lowers their risk of loss and increases their earnings and potential dividend yields.
What’s the most common attribute of investors entering a bull market?
It is their aversion to understanding the how, who, what and where of the company. Instead, they rush in, like fools, in great anticipation of rising share prices.
To be prepared for when the crash occurs, you need to do the following;
- Have a list of companies to buy
- Have an Investment Journal
- Know how to allocate your funds between the companies
- Be patient & disciplined.
Let’s now address each point.
Know thy company.
You will need to have studied and compiled a list of companies. Make a list of 10 companies that you would buy and be willing to hold for ten years.
Here are a few items for your checklist:
- Simple business model.
- Low debt.
- Requires a low amount capital reinvestment.
- High return on capital.
- Strong competitive advantages.
- Free cash flow.
- Competent and honest management.
Why ten and not one hundred?
Firstly, one hundred is too overwhelming, but ten is manageable. The goal is to completely understand each company inside and out, you can’t do that with one hundred companies. Plus when panic sets in, you will know with absolute certainty, if the crisis will negatively impact one of your ten businesses.
For instance, if all ten companies have little to no debt, and don’t rely on external cash flow for operations, then it is immune to a credit crisis.
Remember Buffett’s advice:
“Keep all your eggs in one basket, but watch that basket closely.”
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
Start an investment journal.
An investment journal is an excellent companion for any investor.
When you are conducting the analyses of the ten companies, write or type (your choice) the following questions and answers, to keep as a record.
- How would I explain how the business makes money to a 12-year-old?
- Have I used the product/service they offer?
- How much debt does the company hold on the balance sheet? In current liabilities and non-current liabilities? Why does the business require debt? Check the cash flow statement – is it to pay for reinvestment in PP&E? Or to pay for the businesses strategy of expansion? Are the interest payments sustainable?
- Does the company have a track record or producing free cash flow over 10 years?
- Does the business earn a return on capital in excess of 15 percent?
- Does the company exhibit competitive advantages in the following areas?
- Economies of scale?
By initial recording your analyses of the ten companies – on paper or laptop – you are creating a thesis for each company, which you can update at a later date when new information is released by the company.
Having a record of why to buy or sell at this point in time, will allow you to reflect in the future and avoid past mistakes, and you will be able to develop your own personal checklist.
How you spread your funds across the ten companies will be determined based upon your risk tolerance but primary on the opportunity cost.
“You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”
There is no easy answer here, only you can truly know what your risk tolerance. The best way to find out is by being in the market.
Opportunity cost is one of the most underutilized concepts.
“I would argue that one filter that’s useful in investing is the idea of opportunity costs. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to.”
We all have a limited amount of money to invest, and once we allocate a percent of the total funds to buy one stock, we are giving up the opportunity to buy another stock with those same funds.
For Instance, say we starting out with $10,000 dollars and we buy 10 companies. And assume we have invested $1000 into each stock.
Now the question is how do we decide if we should sell and buy a new investment opportunity in XYZ stock?
And how do we measure the opportunity cost?
A simple rule of thumb to use is to calculate the return on capital each company is earning and compare them. The one with the highest return on capital one wins.
Say your current stock holding – ABC – is earning a return on capital of 15 percent whereas XYZ stock is earning 25 percent. Then you would be wise to sell ABC and buy XYZ.
But beware that you will need to purchase XYZ at the right price! We are assuming in our example that stock XYZ is trading below your calculated intrinsic value, and you have done your research to confirm that XYZ has competitive advantages!
But what if your current ABC stock is trading below what you bought it for?
Don’t worry about it, the long term compounded return of 25 percent trumps 15 percent, plus you can use the loss to offset the future capital gain.
Let’s look at an example:
Google Finance: Based upon most recent annual report
Here we have three semiconductor manufacturers, Advanced Micro Devices, Inc., Intel Corporation and NVIDIA Corporation.
It is quite obvious NVIDIA Corp. will – provided it can maintain those high returns on investment (capital) – compound your money at a faster rate compared to Intel Corp.
So, when someone presented a company in an emerging market to Warren Buffett, Warren said, “I don’t feel more comfortable [buying this] than I feel about adding to our position in Wells Fargo.” He thinks highly of the company and the managers and the position they were in. He was using this as his opportunity cost. He was saying, “Don’t talk about anything unless it’s better than buying more Wells Fargo.” It doesn’t matter to Warren where the opportunity is. He has no preconceived ideas about whether Berkshire’s money ought to be in this or that. He’s scanning the world trying to get his opportunity cost as high as he can so his individual decisions would be better.
Patience and discipline.
A wise old man once said,
“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.”
When Cleveland, Ohio was enduring three and half years of a depression, Rockefeller did two very important things. He didn’t bemoan about the depression but eagerly observed the momentous events.
‘Almost perversely, he chose to look at it all as an opportunity to learn, a baptism in the market. He quietly saved his money and watched what others were did wrong. He saw the weaknesses in the economy that many took for granted and how this left them all unprepared for change or shocks.’ Ryan Holiday
We can apply the discipline and patience Rockefeller practiced.
We can diligently save our money, or better still find ways to earn more, all the time studying and compiling our list of target companies to buy when the crash occurs.
But what do I do if I’m already in the storm?
Most of the options are not very attractive. First, assess your current holdings, if you have done your research this may present an opportunity to buy more (dollar cost average down), but if you determine them not be high quality consider taking losses and selling at moments when the market flickers back to life.
When the war began in Europe in 1939, Sir John Templeton borrowed money to buy 100 shares each in 104 companies selling at one dollar per share or less, including 34 companies that were in bankruptcy. Only four turned out to be worthless, and he turned large profits on the others.
He took the strategy of “buy low, sell high” to an extreme, picking nations, industries, and companies hitting rock-bottom, what he called “points of maximum pessimism.”
“Invest at the maximum point of pessimism.”
Sir John Templeton
Even U.S. President Trump saw an opportunity to invest in New York real estate in 1973, at a time when the city’s real estate market began to suffer due to rising interest rates, high inflation, and debt. He began negotiating his first deal for one hundred acres of undeveloped riverfront property.
“To buy when others are despondently selling and to sell when others are greedily buying.”
Sir John Templeton