The coming crash…

This week was the 10th anniversary of the collapse of US investment bank Lehman Brothers, the event that’s seen as precipitating the Global Financial Crisis. The milestone has many in the media questioning the current bull market, one that is starting to get rather long in the tooth and is showing more than a few red flags.

In fact, parallels are also being drawn to the dot-com crash at the turn of the century. According to Goldman Sachs, the top quartile of the ASX by valuation is trading on an average forward price-to-earning (P/E) multiple of 30, higher than what we saw at the peak of the tech boom. And now, as then, technology stocks feature prominently in this cohort.

Then again, the market has always climbed a wall of worry. There were plenty of smart people calling for a correction last year (remember UBS’ “Sell Everything” call?), and the year before that, and the year before that… Of course, at some point the bears will be correct. Even a broken clock is right twice a day.

The trouble is that market exuberance always goes on longer than you think possible. And study after study shows that those that simply stay fully invested tend to do a lot better, in the long run, than those that try and time market cycles.

Besides, there are still plenty of bulls that feel a market correction is far from imminent. After all, interest rates are far lower than they were in 2007 and 1999, and that alone helps justify higher valuations. The global economy is doing well too, with the US in particular boasting some rather encouraging stats. And as for those tech stocks? Well, perhaps it really is different this time. Unlike in 1999, many of the current high-flyers are businesses with strong revenues and attractive fundamentals. There’s a lot more underpinning these businesses than just site visits.

So what’s an investor to do? At Strawman, we’re mindful that although no one rings a bell at the top, there are some practical steps investors can take to best position themselves for the uncertainty ahead. 

For one, we think it’s important to always keep a level head in terms of value. No business, no matter how great, is worth an infinite amount. Running blind with the herd is not likely to serve you well, so it’s wise to remain focused on the underlying fundamentals of any investment.

Next, consider your time frame. If you’re likely to need access to your capital in the next year or two, it’s probably sensible to take some money off the table — just in case markets get into a wobble. Cash tends to deliver pretty poor returns (more so in this current low interest rate environment) but at least you know it will be there when you need it.

Also, consider the structure of your portfolio. It’s probably not smart to have a selection of highly correlated companies; ones that are exposed to the same risks and profit drivers. For example, owning the big four banks, Macquarie and Bendigo & Adelaide Bank may make you think you have some good diversification, but the reality is that all will behave similarly in an economic slump. Spread your investments across a range of businesses that have different exposures.

We think it’s always a good idea to favour companies with strong balance sheets. History has shown, time and again, that these are the ones that best weather the storm and, indeed, tend to emerge out the other side even stronger. Sure, their share prices will also take a hit when fear grips the market, but the business will endure, and survival won’t be reliant on the good nature of bankers and investors. 

In terms of leverage, if you have invested with borrowed funds, or are using derivative instruments (like CFDs or options) beware that it’s something that magnifies losses as well as gains. Be very, very careful.

Last but not least, remember that you don’t have to be binary in your thinking. This is not a question of being fully invested, or completely in cash. If it helps you sleep better at night, consider reducing your invested capital by a certain fraction. That will not only limit your downside, but gives you some dry powder to take advantage of the fantastic bargains that always accompany market turmoil. And, if the market continues to sail higher, you still get to enjoy the spoils.

Got another suggestion? Or have a different point of view? Jump onto our forums and have your say!

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