Do You Have a Stock Market Exit Strategy?

Jay Peroni, Lead Analyst, CEO and FounderBlog (Members), Blog (Public)

Exit Strategy

Much of the investment world has watched in a state of semi-disbelief as the stock market has continued to reach new highs. In doing so, the market has ignored the Brexit “yes” vote, which we were promised would crush the global economy. It’s also shaken off a series of terrorist attacks, the Chinese debt crisis, a budding banking crisis in Italy, and a coup attempt in Turkey. And that’s just in the past few weeks. It’s buried the time honored saying “sell in May, then go away”.

None of this would be remarkable if we were early in a bull market. But this market is beyond long-in-the-tooth. The S&P 500 has more than tripled in value in just a little over seven years, rising from a March, 2009, low of 676, to the current level of 2100-plus.

It’s looking more like market manipulation is the driving force all the time, as if the market is intentionally set to ignore any bad news. What we’re seeing now is the blow-off phase of an extremely overbought market. The possibility of a crash is increasing each week, as the market further detaches itself from what is clearly a weakening economy.

Do you have a stock market exit strategy? It’s looking like everyone will need one soon. Here are some strategies you should consider in developing yours.

Ask: How Much Am I Prepared to Lose?

Every game eventually comes to an end, no matter how successful it is. It’s not possible to predict where the market will go from here, but the odds of a major decline are much greater than the potential for a large gain. Former White House Budget Director, David Stockman, said in an interview on CNBC that market potential right now is something like 2% upside, 40% downside. We can argue the specific numbers, but the point is very well taken.

It’s time to ask yourself the critical question, “how much an I prepared to lose in the event this market goes into a hard reversal?”

Seriously consider this question, and assign hard number percentages to what kind of loss you are prepared to sustain and continue on your current investment course. Is a 10% acceptable? 20%? 50? Or 0%? A decline of 50% or more is hardly out of the question, since that is exactly what happened in the 2000-2002 crash, and again in the 2007-2009 crash, when the market lost 57% of its value. We should reasonably expect that a 50% decline is well within the range of possibilities.

If you are only prepared to accept a 20% loss in your portfolio, then you will need to reduce your stock exposure to 40%. In that case, a 50% market wide loss would translate into a 20% loss (40% X 50%) to your portfolio. Meanwhile, the 40% exposure that you will maintain will provide you with some participation in future gains, should the market continue on the current path of “extend and pretend”.

Take Profits Liberally

One of the first rules of making money in the stock market is to not lose it. Given the excessive valuations in this market, traditional buy-and-hold strategies could work against you. If you do plan to sell positions down to an acceptable loss level, it should start with stocks that have the richest valuations.

Though bull markets may reward stocks with nosebleed P/E ratios, bear markets favor value.  The S&P P/E is currently at 24, which is very high from a historic perspective.  The coming down cycle may lose confidence in the ability of growth oriented companies to continue growing. Once they do, many of today’s high fliers could become orphans in a matter of months. Get out before the bloodbath hits, and you may be able to buy back the same stocks at much more reasonable prices, post-crash.

Keep Fresh Capital Flowing in Cash  

Whether you intend to reduce your stock exposure or not, any fresh capital that you are moving into your portfolio should be held in cash. Not only will this reduce your stock exposure, but it will also enable you to build up liquid reserves to buy stocks at bargain prices after the worst of the crash has passed.

Using Stop-Loss Orders

You can use stop loss orders to keep your stock positions from losing too much money. For example, if you’re willing to accept a 20% loss in your portfolio, then you can set a stop loss at 80% of the current price of any stocks that you want to hold. If the stock price falls, and the stop loss is triggered, the stocks will be sold automatically, removing any emotional factors or indecision from consideration.

Following stocks down in the hope of a sudden price recovery can lead to bigger losses than you’ve ever imagined.

Bear markets, especially those triggered by sudden crashes, require an entirely different way of thinking about the market, as well as the investing strategies that you should employ.

Short Sales

Short Selling enables you to make money on stocks that decline in price. In effect, you are selling a stock at today’s price, with the idea of buying it back at a later date, with a profit earned as a result of the lower future price. In order to do this, you have to borrow stock that you will be selling from the broker. That will require selling it on margin, which will also require interest expenses.

In theory, it could be a perfect profit generating strategy in a declining market. However, given that this market is being perpetually manipulated to the upside, and that there is no way to tell how much longer that can continue, betting against this market could be a strategic error.

The problem with short selling is that it’s an unbalanced arrangement. When you buy a stock, you have unlimited potential growth, but your losses are limited to your investment. The situation is reversed with short sales. Your gain is limited to the current value of the stock, while potential losses are virtually unlimited.

If You Want to Invest in New Securities, Dollar Cost Average Your Way In

If there are any particular sectors or securities that you want to invest in, it’s best to do so through dollar-cost-averaging. If you want to invest $10,000 in an index fund that invests in a sector like healthcare or technology, plan to do it gradually over six months or a year. Our 3rd Quarter Buy List is a great place to start!

If the market starts heading down, you will buy into the investment at progressively lower prices. By contrast, if you plunge into the market at its current high levels, and a crash follows, you can see 50% of your investment wiped out in a matter of months. Dollar cost averaging will reduce the amount you will lose even in a crash.

Seriously Consider Alternative Investments  

Two sectors to consider right now are energy and precious metals. You don’t want to load your money into either sector, but maintaining a small position in each may prove to be the best single investment that you make in the next couple of years.

The energy sector, and particularly oil and coal, have already experienced bear market blowouts. Many stocks in this sector are currently trading well below their previous peaks. That means that they have less downside risk than the general market, and considerably more upside potential. This is especially true since bear markets often cause global economic stress, that can lead to revolutions and military conflicts that might interrupt the free flow of oil from less stable regions of the world.

Gold and silver went through their own bear market cycle for the past several years, flushing out a lot of the speculation. But they’ve rebounded nicely year-to-date, and seem to be more in step with the real state of global economic, financial, political, and geopolitical realities.

A major drop in stocks, accompanied by the increasing likelihood of sovereign debt defaults would strongly benefit precious metals, which typically move in inverse proportions to bonds and currencies.

Energy and precious metals may represent the only serious counter plays in either a stock market crash or a protracted bear market.

This is an outstanding time to resolve that you will not be victim in what is rapidly lining up as the third stock market crash of this very young century. This may be the last chance to get out while you still can.

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