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This is an opinion column. The thoughts expressed are those of the author.


The Coming Meltdown
Sam Pearson 4/30/2021 4:18 PM

 

Financial planning is but a series of mathematical formulas applied along the line of a statistical study. That being said, I have some bad news for you. I hate to say it. But it's just the nature of government interference in simple business cycles.

When a stock Melt Up ends, and the Melt Down is in full effect, everyone you know will lose more on the way down than they needed to unless they have an exit plan. 

I hate that this will happen to a lot of great people. I know that this will even happen to many of our most educated investors. The truth is that these investors will do it to themselves.

One can put up all the warnings of a future stock meltdown, however, at the peak, people will fall in love with their previous stock performance and not heed the most obvious of warnings.

They will believe they will be able to make back a short-term loss. They will believe their stocks will come back quickly and ultimately; they will ride them a lot lower than they should. The powerful uptrend reverses, and it becomes a powerful downtrend.

However, I also have some good news...

The good news is that one can avoid these long-term impacts to one’s portfolio, but to avoid it, you have to start thinking differently. 

Let’s look at a little recent history. If you are over 60 you may recall Black Monday. This is the name commonly attached to the global, sudden, severe, and largely unexpected stock market crash on October 19, 1987. In Australia and New Zealand, the day is also referred to as Black Tuesday because of the time zone difference from the United States.

All the twenty-three major world markets experienced a sharp decline in October 1987. When measured in United States dollars, eight markets declined by 20 to 29%, three by 30 to 39% (Malaysia, Mexico and New Zealand), and three by more than 40% (Hong Kong, Australia and Singapore). The least affected was Austria (a fall of 11.4%) while the most affected was Hong Kong with a drop of 45.8%. Out of twenty-three major industrial countries, nineteen had a decline greater than 20%. Worldwide losses were estimated at US$1.71 trillion. The severity of the crash sparked fears of extended economic instability or even a reprise of the Great DepressionNo definitive conclusions have been reached about the reasons for the 1987 crash. Stocks had been in a multi-year bull run and market price–earnings ratios in the U.S. were above the post-war average. The S&P 500 was trading at 23-times earnings, a postwar high and well above the average of 14.5-times earnings.[1] Many investors participate in “Herd behavior and psychological feedback loops play a critical part in all stock market crashes but analysts have also tried to look for external triggering events. Aside from the general worries of stock market overvaluation, blame for the collapse has been apportioned to such factors as program trading, portfolio insurance and derivatives, and prior news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling United States dollar, which seemed to imply future interest rate hikes). 

Those of you 50 and older may recall the financial crisis of 2007–2008, also known as the global financial crisis (GFC), was a severe worldwide financial crisis. Excessive risk-taking by banks

 

The problem with the economy is the loss of close to $6 trillion in housing wealth and an even larger amount of stock wealth. 

U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion. The increase in cash out refinancing, as home values rose, fueled an increase in consumption that could no longer be sustained when home prices declined. Many financial institutions owned investments whose value was based on home mortgages such as mortgage-backed securities, or credit derivatives used to insure them against failure, which declined in value significantly. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.[2]

Having a stock crash on you is part of investing in stocks... It's a risk you take every day that you're invested in the market.

But when you get out of the markets, you have two decisions you must get correct: when to get out and when to get back in. Each decision often must be within weeks or sometimes days of the optimum moment.

Here's what you need to do...

When a stock you own is crashing, you need to ask yourself two things:

Is the reason I bought it still valid?

If you bought a tiny biotech stock because you thought its drug was going to succeed, but it failed, you need to get out... Don't say, "Well, the company has other things cooking, too" or "Well, I've lost SO MUCH already, how much worse can it get?"

Don't catch yourself saying either of those things. If the reason you bought the stock is no longer valid, get out.

What is my "point of maximum pain"?

How much are you willing to lose before tears begin to exit the corners of your eyes and cry "uncle"?

You should try to define this point when you enter the trade. That way, you've made a rational decision to sell in advance, not an emotional decision right at the moment the stock is down.

The important thing here is, I have a plan. I'm not holding and hoping. I'm not panicking and selling.

I have an exit strategy.

What do you do when your stock is crashing? Do you:

  •                   Hold and hope?
  •                   Panic and sell?
  •                   Have an exit strategy?

 

This is a 3-part discussion; Part 2 will discuss why we are headed into a Melt Down in the next 180 days, and when one should consider executing their Exit Plan. Part 3 will discuss when one should consider re-entry to the equites market. 

The Equites market is in my opinion and experience where most investors can get the best and most consistent returns from their investments. Even accounting for the meltdowns and poor business performances in the graphic below are the returns of the S&P 500.

[3]

 


[1] Bates, David S. (1991). "The Crash of ʼ87: Was It Expected? The Evidence from Options Markets". The Journal of Finance. 46 (3): 1009–1044. doi:10.1111/j.1540-6261.1991.tb03775.x.

 

[2]  Williams, Mark (2010). Uncontrolled Risk. McGraw-Hill Education. p. 213. ISBN 978-0-07-163829-6.

 

[3] Dicle, M. F., & Levendis, J. (2020). Historic risk and implied volatility. Global Finance Journal, 45, 100475. https://doi.org/10.1016/j.gfj.2019.100475

 



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Sam Pearson
Sam Pearson is a retired Army Colonel with a variety of experience in both government and private sectors. As arguably one of the World's foremost military logisticians, he has been responsible for the on time delivery of supplies and services worth billions of dollars. After service in Southwest Asia, he was hand picked to support logistics operations in support of earthquake relief operations in Haiti. Pearson now serves as a consultant and volunteer mentor for students seeking their doctorates in advance statistical analysis.




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