It may be days, weeks, months or even years away, but inevitably the stock market—which has more than doubled over the past four years and hit new record highs this year—will descend, as many analysts warn and as history has shown.
How big that drop will be and how long it will last are open to debate. In fact, a large number of analysts contend that the bull market still has plenty of pep, which would mean that you don’t have to take extreme defensive steps for a while (see below).
But even so, it’s important to think about your own financial situation and how it could be affected by an extended pullback, especially because the traditional strategy of shifting toward bonds or bond funds may not work as well this time as in the past. Interest rates are so low that they could surge—hurting bond prices badly. That could happen in the next few years as the economy strengthens and the unemployment rate drops.
Bottom Line/Personal asked four top market strategists to each describe his/her favorite way (in one case, a radical approach and, in others, a more moderate approach) to start preparing so that you can cushion your portfolio once a stock market pullback begins…
Does the idea of selling off all of your stock holdings now and possibly sidestepping another drop of more than 50% like the one in the 2008–09 financial crisis sound attractive? This is, of course, a radical approach, and if the market continues to rise, people who take this approach would miss out on future profits. But if you have saved up enough money that you could live off of a very modest yield from short-term savings and some bonds (possibly with the help of Social Security and a pension), it might be a viable option. This works best for people whose stocks are mostly in tax-protected retirement accounts, such as 401(k)s and traditional IRAs and Roth IRAs, so that the sale of stocks does not trigger capital gains taxes.
For taxable savings accounts, you might want to stretch out the sales over a period of a few years. That way, you can avoid realizing so much in capital gains from the stock sales in any given year that you push yourself into a much higher tax bracket.
As you sell the stocks, you might want to use some of the cash proceeds from those sales to help pay off outstanding credit card balances, car loans and other debts that have high interest rates.
Other than paying off bills, there are a variety of ways that you could invest the bulk of the cash proceeds from the stock sales, but if you want to be supersafe, consider a mix of savings and/or money market accounts for short-term use, certificates of deposit (CDs) and US Treasury securities. Three-year CDs pay up to 1.3% currently…five-year CDs pay up to 1.7%…and 30-year Treasuries pay around 3%—so depending on how much of your money you put into the bonds, you may end up with an overall yield in the 2% range.
That’s very little, but at least it’s ahead of the current inflation rate. During a prolonged period of weak stock prices, you wouldn’t have to worry about having to liquidate investments at the worst possible time. With this strategy, if there is a major stock market pullback, you can, of course, move back into the market at bargain prices. Also, as interest rates rise, you can invest proceeds from maturing CDs in higher-yielding CDs and Treasuries. Even if the value of your Treasuries drops as a result of rising interest rates, you won’t suffer losses if you don’t sell the Treasuries early, and you will continue to get their guaranteed 3% yield year after year.
If you are not in a position—or of a mind—to cash in all your stocks, you might want to consider paring back your stock holdings, especially the riskiest ones.
Start by reducing your allocations to areas of the market that are most vulnerable to a big sell-off—either because they are overvalued right now (the home-builder, utility and oil-service sectors, in my opinion) or because they sell for hundreds of dollars per share, making them seem pricey. Panicky investors tend to dump these first. Next, reevaluate the potential of stocks you still own that have had a substantial run-up in 2013.
Example: My shares of Boston Beer Company (SAM), the largest microbrewery in the US, rose 20% this year through the middle of April. Premium beers are a fast-growing niche, and I think the stock has more upside. But to be prudent, I’m selling an amount equal to my initial investment. That way, in the worst-case scenario—a plunging market—I give up some profit, but I always at least break even.
In addition to paring back on your riskiest stocks, you might want to shift to much safer ones. Look for stocks of companies that pay decent dividends that have increased year after year even through recessions…have products or services that are so ingrained in business and consumer life that they have been able to survive and profit no matter how bad the economy gets…and have held up well in market declines and always bounced back, beating the Standard & Poor’s 500 stock index over the long run.
Examples of stocks to buy and/or keep…
Air Products and Chemicals (APD), which is in 50 countries, is the dominant global manufacturer of industrial gases essential to the production of products as diverse as beer, golf balls, rubber gloves and rockets. Recent yield: 3.3%. Recent share price: $86.96.
Automatic Data Processing (ADP) is among a handful of US companies with a triple-A credit rating, and it is a leading provider of outsourcing services, including managing payrolls and employee records for more than a half-million businesses. Recent yield: 2.6%. Recent share price: $67.34.
Archer Daniels Midland Company (ADM) is one of the world’s largest processors of corn, wheat and other agricultural products and a top producer of vegetable oil, ethanol and animal-feed ingredients. Recent yield: 2.3%. Recent share price: $33.94.
ConocoPhillips (COP), the third-largest US oil company, has secured future growth with recent large discoveries in the Gulf of Mexico and major operations in the growing US shale oil-drilling industry. Recent yield: 4.5%. Recent share price: $60.45.
Genuine Parts Company (GPC) distributes automotive and industrial replacement parts throughout North America and supplies auto-repair shops through its NAPA brand. The company’s very consistent cash flow has allowed it to raise annual dividend payouts 57 years in a row. Recent yield: 2.9%. Recent share price: $76.33.
PepsiCo (PEP) has well-known brands including Pepsi, Mountain Dew, Gatorade, Tropicana, Lay’s, Doritos and Quaker. It will continue to prosper in developed markets, along with competitors such as Coca-Cola and Kraft, and has barely begun to penetrate some of the world’s largest emerging markets, such as China and India. Recent yield: 2.6%. Recent share price: $82.47.
Rather than concentrating on individual stocks—even relatively safe ones—you might want to ride out a prolonged pullback with cautious mutual funds. They give you an opportunity to profit when the market is rising but offer substantial protection in declines. They often hold a significant amount of cash when their managers believe that the market is overvalued and/or that they can’t find stocks they believe are worth investing in. And these funds’ portfolios have a low “beta,” a common measure of a fund’s sensitivity to market movements as compared with the S&P 500.
Cautious funds to consider…
Copley Fund (COPLX), a conservative large-cap value fund with a beta of 0.39 (versus 1 for the S&P 500), lost just 15.6% in the 2008 market plunge, compared with a 37% drop for the S&P 500. 10-year annualized performance: 6.1%.
T. Rowe Price Capital Appreciation Fund (PRWCX), a large-cap fund that has both growth and value stocks, has suffered an annual loss in only two of the past 25 years. 10-year annualized performance: 10%.
Yacktman Focused Fund (YAFFX) looks for large, high-quality businesses with cheap stock prices. Its performance puts it in the top 1% of funds in its category over the past 10 years, outperforming the S&P 500 by an annual average of five percentage points. 10-year annualized performance: 11.9%.
