MIAMI (MarketWatch) — Investors who are deeply afraid of a stock market crash suffer from a condition I call “crashitis.” Symptoms include anxiety, insomnia, anger, and negative thoughts about the market. People in this condition often move all their money to cash even in bull markets. In extreme cases, investors may avoid the market for a lifetime.
After getting burned in the market twice in the last 10 years, it’s not surprising that many investors are suspicious of this market. It’s been said this is the most hated bull market in history.
Unfortunately, the fear of a market crash — crashitis — is worse than a crash itself. In truth, and based on probabilities and history, there are usually warnings before a correction or crash.
The boy who cried ‘crash’
The worst part of being afraid is the lost financial opportunity. Listening to doomsayers who constantly cry “crash” hurts your portfolio. Just like Chicken Little who thought the sky was falling when an acorn hit her on the head, a market correction will bring forth a wave of new crash predictions.
If there is a correction, don’t be surprised if the market disappoints everyone. Consider: The market bounces back after a pullback or sharp correction. Those expecting a huge crash (so they can buy at lower prices) won’t get it. Those thinking the bull market will continue indefinitely will lose money.
The cure for crashitis
Rather than succumb to your fears, prepare for the worst. Eventually, there will be a bear market. Create a diversified portfolio, understand the stocks and mutual funds you own, and develop portfolios for both long-term and short-term goals.
The cure for crashitis is a healthy dose of knowledge. This will help you to control your emotions and focus on the facts (such as market indicators) rather than your fears.
What the indicators say
Although a major market crash is a relatively rare event, a pullback (3% to 9%) or even a large correction (10% to 20%) is more probable. The odds of a pullback or correction have recently increased.
In fact, the indicators are flashing caution signs:
MACD dropped below the signal line, the Standard & Poor’s 500-stock index (SNC:SPX) fell below its 20-day moving average (a short-term signal), and the put-call ratio is below .75 (option buyers are too bullish, a contrarian signal). It is too early to know if these signals are significant, so we look at outside events for additional clues.
1. Japan’s Nikkei stock index fell by 7 % in a day, rallied somewhat, but was off its peak by 15% at one point.
2. There was an uptick in yields in the U.S. bond market, a signal that bond investors could get hurt, especially as the Fed slows down its bond buying program. Bill Gross, the bond guru at Pimco, warned that the bond rally is over.
3. Emerging market currencies got crushed (South Africa, Thailand, Turkey, Peru) and bond yields spiked (Turkey, South Africa, Mexico, Hungary, Poland). The governments in these countries could react by raising interest rates.
4. A distressing development for the bulls was institutional selling at the end of four days last week (i.e. distribution). This was not a good sign.
Prepare for the worst
When storm clouds appear, you should take defensive actions. This doesn’t mean to panic and sell everything. Here are a few steps you can take to prepare for a correction:
1. Cut back on individual stocks, especially if you have losing positions. If there is a correction, those small losers turn into big losers.
2. Hedge with non-leveraged inverse ETFs. (Avoid leveraged ETFs, which contain questionable securities and have a tendency of doing reverse-splits.)
3. Buy protective put options. Start small with a few contracts. Although you can make money during a correction, it’s not easy; you have to be right about the timing and direction.
4. Have cash set aside for emergencies and to buy into future bull markets.
5. If you know what you own and are comfortable holding, you can survive a correction. It will not be the end of the markets as we know it, but if you believe that, you have crashitis.
The biggest danger is that fear causes you to do something irrational like selling at the bottom or keeping all of your money in cash for years and years.
If there is a correction or crash, the market will survive. No matter how many times the market has been hit, it always comes back eventually.
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