What if the Markets Crash?

Global markets appear set to tumble…

Trade wars, falling house prices, extreme debt, a crisis in Turkey, and defaults in China.

The alarm bells are ringing loudly.

Forget stocks. It’s time to cash-up and prepare for the worst.

Well, at least that’s what some experts are saying.

You don’t have to look far for a dose of negativity. Dire forecasts aren’t hard to find. And I’m not just talking about niche business websites. Some big names are speaking out.

Have a read below…

In 2020, Wile E. Coyote is going to go off the cliff and look down.

Ben Bernanke, former chair of the Federal Reserve

There are two bubbles: a stock market bubble and a bond market bubble.

Alan Greenspan, former head of the Fed

…markets are potentially on a collision course for disaster.

Scott Minerd, Guggenheim Partners chief investment officer

Yes, this is scary stuff.

And the experts all seem to have compelling arguments to back their predictions. I can understand why people are nervous. It sounds like the conditions for a collapse are aligning.

So should you sell-up and hunker down?

Now, I’d like to assure you the worst won’t happen.

But I can’t. I simply don’t know.

The clever people making the scary predictions could be right.

This might be the beginning of the end.

But the truth is, no one knows.

You see, forecasts of a financial apocalypse are nothing new. People have been making dire predictions since I began my career in 1991. And so far, they’ve mostly been wrong.

They say markets climb a wall of worry. And you know what. They do.

Since 2009, the Dow Jones has tripled from 6,443 to an all-time high of 25,728.

And do you know the one common theme during this time?

It’s been the doomsayers.

Year in, year out, they’ve said the rally wouldn’t last.

A popular catchcry of the pessimists is ‘the end game’. They often use the phrase to highlight their view of an imminent implosion of the financial system.

I remember the same sort of thing happening during the 1990s. A prominent forecaster was predicting the Dow would crash to 100. That’s right, 100!

And he had a persuasive case. A lot of people followed his service…including myself.

Yes, the 90s had its share of panics. There were scary headlines, and plenty of reasons to worry.

But the worst of the predictions didn’t happen…they rarely do. Life went on, and the markets continued their centuries long climb up the wall of worry.

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Historian and economics professor Deirdre McCloskey sums it up beautifully:

For reasons I have never understood, people like to hear that the world is going to hell…yet pessimism has consistently been a poor guide to the modern economic world.

Now, don’t get me wrong.

I’m not saying that stock markets never crash — they most certainly do.

But in my experience, the answer isn’t to cash-up and sit tight. Most of the time the world moves on without the pessimists. All the opportunities go to those who stay in the game.

What should you do if the markets crash?

I’m going to answer this with three examples.

You’re going to see an alternative to bunkering down in uncertain times.

The examples show how Quant Trader responds to market turmoil. All the examples are from back-testing.

Here’s the first:

MoneyMorning 28-09-18

Source: BigCharts
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You’re looking at a chart of the All Ordinaries. It covers the period from July 1996 to July 1999.

This was a volatile time. It includes three seismic events: the Asian Financial Crisis, the Russian debt default, and the collapse of a major hedge fund. 

The most violent fall was in October 1997. Stocks were at a record high. Then, without warning, the market lost 20% in a month. This includes a one-day drop of 12%.

Many people thought the financial system would implode. Here’s what one leading economist and hedge fund manager was saying in August 1998:

The collapse of Russia is having a profound impact upon the entire global financial markets… Of all the great financial panics in history, this one looks like, sounds like and moves like none other than 1929 all over again. The similarities of what we are living through have more in common with the fundamentals behind the Great Depression than at any other point in time.

Martin A Armstrong

Yes, this was a scary time. My employer, Bankers Trust, went out of business during this period.

Now let me show you how Quant Trader manages the uncertainty:

MoneyMorning 28-09-18

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It’s not plain sailing by any means. This was an incredibly testing environment. The chart shows the hypothetical profits from long trades. It doesn’t include costs and dividends.

You’ll see the sharp drop near the middle of the chart. The Asian meltdown was in full swing. This is when stocks lost 12% in a single day. It’s the sort of situation some people fear today.

Now, let me be straight with you…

Heavy falls are a reality of stock trading. The only way to avoid them is to stay out of the market. But I believe that’s a big price for an infrequent event.

An alternative is to use strategies that aim to limit losses. You’ll still have losses. But you’ll have an exit route when things turn bad. You’ll also have a plan to get back in when conditions improve.

Look at how Quant Trader manages the fallout from the Asian crisis. There’s an initial loss as the market falls and exit stops are hit. The system then steadies before recovering to new highs.

Let me show you another:

MoneyMorning 28-09-18

Source: BigCharts
[Click to open new window]

This is the All Ordinaries from January 2001 to May 2002. The big event of the time was 9/11. If you were in long stocks, you almost certainly lost money.

Here’s how Quant Trader performs:

MoneyMorning 28-09-18

[Click to open new window]

Quant Trader doesn’t escape the selloff. Most of the portfolio’s stocks fall. 50 companies trigger exit stops during the following two weeks. The system gives back much of the year’s profit.

As before, the results are only for long trades. I’m leaving out short positions. I want you to see how a long-only portfolio performs.

The flipside of a crash is the recovery…

If you minimise losses during the selloff, you’ll be in a better position to take advantage of the upswing. This is exactly what Quant Trader does in the following months.

I have one more example. This is from more recent times:

MoneyMorning 28-09-18

Source: BigCharts
[Click to open new window]

You’re looking at the All Ordinaries between July 2010 and December 2012. This was during the European sovereign debt crisis. There was also a downgrade of the US credit rating.

This was another worrying time. Many experts were expecting the worst. Predictions of a second GFC were commonplace. But many of the warnings came after the big stock market falls.

Here’s what Quant Trader’s portfolio does:

MoneyMorning 28-09-18

[Click to open new window]

Quant Trader gives back profits during the crisis.

But unlike the All Ordinaries, the system doesn’t go into the red. It exits trades as they hit their stops. This protects capital from continuing losses.

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Now, you may be wondering about the drop in Quant Trader’s profits (from $50,000 to under $10,000).

Yes, this is a big fall. But it’s for a large portfolio.

You see, at the market’s peak, there were 204 open trades, with a hypothetical value of over $250,000. This puts the drawdown into perspective.

There’s no shortage of global concerns at present. Experts constantly remind us of the potential dangers. Many traders are asking if they should be in the market at all.

But here’s the thing: You don’t need to know the future to trade stocks.

Successful trading is about having a robust process — not a crystal ball.

Strategies like following the trend, running profits, cutting losses, and having many relatively small trades are defences to uncertainty. They help you deal with whatever the future brings.

Yes, the markets could crash. That’s why we have exit stops. It’s also why spreading risk is so important. These strategies aim to protect you from the worst scenarios.

I believe the biggest risk is to avoid the market completely.

People ask me: What if the market crashes?

I say, what if it doesn’t?

In my experience, a good strategy ultimately comes out on top.

Until next week,

Jason McIntosh,
Editor, Quant Trader

Editor’s note: I believe the best defence against uncertainty is a proven strategy. This helps keep you in the market as it climbs the ‘wall of worry’, and provides an exit plan for when conditions change.

Don’t let uncertainty keep you out of the market. If you need a strategy for uncertain times, then check out my premium advisory service, Quant Trader. It could change the way you trade forever.

All graphics produced by Quant Trader unless otherwise noted.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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