The S&P 500 recently hit fresh highs, which also coincided with the longest bull run ever. The S&P 500 is an American stock market index based on the market capitalization of the 500 largest companies having stock listed on the New York Stock Exchange or the Nasdaq. The index is a useful snapshot of the economic health of the United States, focussing on the biggest US businesses. As of 31 August 2018, it closed at 2,901.52.

I live in the United Kingdom, why should I care? Good question.

Given the United States’ prominent economic role in this world and the US dollar’s status as the (still) leading reserve currency in the word, whatever happens in the US usually ends up affecting other economies. This includes the European and British economies. The last recession started in the US but quickly spread to the rest of the world.

Also, the recent strengthening of the dollar is linked with the plummeting of the currencies of countries such as Argentina and Turkey. Finally, even central bankers pay close attention to the Federal Reserve’s latest moves to determine the impact of any US rate rise on their currencies and their respective economies.

In other words, the US may not cause the next recession but if its economy is in trouble, be sure that we are also in trouble.

The charts do not lie. Even if stocks tend to go up over the long run due to a growing population and increased production, there are drops, corrections, and even bear markets. This bull run will come to an end and when it does, I hope your contingency plans are ready.

This post is especially addressed to millenials who have started investing in the stock market but who have never encountered a true bear market. For too many people, the only recollection of the 2008 crisis revolves around one movie: The Big Short. Now, it is a great movie. Watching it though won’t prepare you enough for a 20% loss in your stock portfolio.

 

Steps to make money in the next downturn

1. Acknowledge that the downturn is here to prepare yourself mentally

This is arguably the hardest step because it assumes that you can determine early on that the downturn is here. According to the US National Bureau of Economic Research, the last recession began in December 2007 and ended in June 2009. I, however, suspect that many people only acknowledged the crisis when Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. Based on that assumption, there was a 9-month lag where you may have continued to “buy the dip” or “double-down.” Yet, the bottom was only reached a year later in June 2009. This is a long time to bleed money.

Determining the beginning of a downturn is hard. Some people are better at it and they have an early advantage. But eventually, you will come to that determination, and it will occur before the indeces hit the bottom. Take the last recession as an example. Unless you were living under a rock, it was hard not to imagine that a downturn was coming after the bankruptcy of Lehman. The dramatic tone of newsreports is often a good hint that something is happening.

At last, countries in the midst of a downturn do not export a recession instantly to other countries. Even with the US, there is a time lag before people start to realize that the downturn might be global and not country specific. For instance, people living in the UK had a slight advantage as long as they were paying attention to the unfolding events in the US and taking precautionary steps. According to the ONS, the GDP only started to nosedive in Q1 of 2018. This is almost a year after the beginning of the US downturn and 6 months after the collapse of Lehman.

2. Be OK with not making any money

As soon as you realize that the downturn is here, you must come to terms with the fact that you may not make any money at all for an extended period of time. In other words, the first step to make money is to understand that you may not make any money in a downturn.

For the past ten years or so, investing in an index fund made you money without doing anything. Investing in Amazon and Apple made you a lot of money without doing anything. The point is that you could sit back and enjoy double digit gains. During a downturn, this does not work. You need to (i) come up with a plan and (ii) understand that your plan may only mitigate losses and not make you any money, which seems unfair if you look back at the effort you put into your index fund or Amazon gains.

It is hard to miss out on gains but the only way not to lose is to not play the game at all. If this has been your strategy for the past four years, you lost tremeduous potential gains on top of having inflation eating your buying power. But if disciplined, you may have a lot of disposable cash to deploy in the next downturn.

Timing the right asset allocation is everything. A proper asset allocation will minimize risk exposure during the next recession.

3. Come up with a plan and an asset allocation strategy – and stick to it

Some plans are usually better than others.

The ideal plan is to determine that a downturn is coming, sell risky assets such as stock and real estate, and go short the market. That is the ideal plan: you made money during the bull market, and you are making a killing in the recession. Unfortunately, it is incredibly hard to do. Even in the movie The Big Short, remember that Dr. Michael Burry was 20% down at some point. And that was someone who had properly timed the housing crisis.

There are however other strategies. The returns might not be as impressive but they are worth a look:

• Do nothing

The most expensive mistake is to panick and sell in a hurry. Nine times out of ten, the selling will occur at the worst possible time, which is when the market is about to bottom out and recover. Many millenials or younger investors are prone to making that mistake because they have never lived a downturn. They simply do not have the experience and the composure to sit tight and watch the world burning.

The charts above show that stocks tend to go up over the long term. If your portfolio is well-diversified, your stocks are likely to recover. You may suffer a complete loss if you purchased a Bear Stern or Northern Rock. It might take ten years to recoup your initial investments. But in the long run, based on precedents, your porfolio will slowly recover and increase in value.

Doing nothing is far from being the best strategy. But doing nothing is still better than suddenly changing strategy, panicking, selling in a hurry at a massive loss and missing the early recovery post-recession.

• Go cash and deleverage

Bull markets last on average approximately 8 years. If you assume that the recession ended in 2009, we are in our tenth year of the bull run. In other words, a downturn or recession is overdue. From discussions with investment bankers and economists (not a representative sample), it is likely that a significant downturn will occur by the year 2020. In the UK, Brexit could potentially move forward the timeline by 6 months if there is no deal with the European Union in order to account for short-term disruptions. Caveat: I am not claiming that Brexit is good or bad in the long run. I am however claiming that short-term disruptions due to a chaotic exit of the European Union could amplify the negative effects caused by a global downturn.

If you believe that the downturn will occur in 2020, the strategy is to move to cash. Progressively selling stocks and building up cash reserves, including with your ISA account, should be the priority. For real estate, the picture is mixed in the UK as it depends on the type of asset and the location of that asset. As a rule of thumb, do not sell your principal residence even if you think that real estate prices in your area are about to nosedive. It is not worth the stress and the transaction costs. If living in London, it is probably almost too late to sell buy-to-let properties without a loss. Outside of London, the market is picking up after stalling for a decade, so there should be opportunities. Be mindful however that the government has been punishing buy-to-let investors recently. Run the numbers based on your situations.

Going cash in the UK is a bit more painful than other countries because inflation is high due to the depreciation of the pound and saving rates remain stubbornly low in spite of the recent Bank of England quarter-point increase. Still, you should be able to earn 1.3% to 1.5% in a flexible cash ISA, and maybe a 1% in a standard savings account. Avoid blocking your cash for a long period in the hope of locking a higher interest rate. In a downturn, you will want the flexibility to deploy your cash and go bargain-hunting. Also, the higher interest rate is unlikely to make any difference to your net worth.

• Short the market

To make money, you need to take risks. If you do nothing, you will lose money but it won’t be as bad as panic selling. If you go cash, you will not make money for a while but will be in a good position to pick up cheap assets and stocks when the recovery begins. But if you truly want to make money in a downturn, you need to go short. This means losing almost everything if the downturn never comes.

 

How do I short the market?

For the average person, buying an ETF that aims at replicating the inverse performance of an index is the easiest way to short the market. In the UK, the following ETFs are available:

• The FTSE 100 Short Daily UCITS ETF (ticker: XUKS) seeks to reflect the inverse daily performance of the FTSE 100 Index. To achieve its goal, the ETF uses derivatives such as swaps.
• The FTSE 100 Super Short Strat2X GBP GO UCITS ETF (ticker: SUK2) aims at replicating twice the inverse daily exposure of the FTSE 100.
• The ETFS 3x Daily Short FTSE 100 ETF (ticker: UK3S) aims at replicating three times the inverse daily exposure of the FTSE 100.

There are plenty of other ETFs available and they are regularly reviewed by the institutions managing them so do some research first.

Prior to continuing, ETFs have a major weakness, which can prove deadly in the long run. Due to how compounding works, an ETF’s performance will diverge from the index’s performance in the long run. ETFs are meant to replicate daily performances. If you hold them in the long run, in a volatile but flat market, you may lose money. There is a good blog post explaining this phenomenon on Monevator.com and I invite you to check it out.

To short the US market, below are a couple of inverse ETFs:

The second option is to short individual stocks. This means borrowing a stock, selling it and rebuying it at a later date once the stock price has (hopefully) decreased. This tactic is a bit more involved as it supposes that you have done some research or at least that you have an edge in stock-picking. You can also short a company by buying put options. Be mindful that options are not for beginners: if you do not understand the risks associated with time decay and volatility, then you are probably not ready. In a downturn, stocks with limited to no earnings and weak balance sheets are the most vulnerable (small tech startups and biotech companies that are not profitable are prime suspects). Utility providers are however safer.

 

Other options to bet against the market

Long Gold

Gold is an asset that tends to well in a recession. As a hard asset, it is generally viewed that its value will at least hold itself over time. Look at how people in countries with spiraling inflation and no access to foreign currencies always fall back on gold to safeguard the value of their savings.

The GLD ETF did well in during the 2008 crisis until 2012, which is when the bull market took off around the world. Beware that gold does not generate a dividend. Also, buying an ETF does not allow you to trade the commodity itself as it is only an instrument to gain exposure.

Long Gilt

Gilt-edged securities are bonds issued by the UK Government. There are similar to the US Treasury bonds in the United States. For readers based outside the UK, the gilt referred to the paper certificates which had a gilt (or gilded) edge at the time.

Because this is government debt, it is presumed to be safe. Yields are typically low. In a downturn, even a low yield is better than suffering a sell-off in stocks. Also, the value of your security may appreciate if investors all seek refuge in government-backed debt.

There are usually two ways of buying gilts. First, you can go to the Government’s Debt Management Office where new securities are issued. Second, you can buy gilts through a stockbroker or through the Bank of England’s broker. Most online brokers should also be set-up in a way to allow you to buy gilts.

Long yourself

It sounds cliché but investing in yourself is an investment that does not depreciate. Whatever you learned, that skill will be yours and you own it. It’s also the easiest asset to carry around and it is (essentially) tax-free.

Investing in yourself does not necessarily amount to getting an MBA. That is the traditional route, one that will cost you to the tune of at least £80,000 in the UK or $200,000 in the US. If you intend to get an MBA, please try to aim for the top schools only, whether in the UK or in the US. With that price tag, there is little room for mistake. The other option is to go through a bootcamp (coding bootcamps are popular) or even start learning through one of those free platforms such as EDX or Coursera.

Better study something fun than watching your portfolio burn to the ground.