Is there going to be another market crash? We are certainly due one, as it has been a decade since the last major correction in stocks. Since then low interest rates and quantitative easing have been driving share prices to new record levels.

At the time of writing the FTSE 100 was north of 7500 points. Before the Great Financial Crisis started to bite, it was at around 6200. Before the wheels came off the dot com boom in 2000 it was at 6900. This certainly seems to indicate that the FTSE 100 and other indexes are now moving into uncharted territory, and in turn, we could be in for a correction.

But what should you be investing in rather than stocks or simply riding the index? Where to put your money before the market crashes?

Historical evidence from the last 30 years shows that the FTSE would be eminently capable of falling to 4000 if we saw another spectacular crash – that’s almost 50% wiped off your share portfolio, potentially in a matter of weeks.

Where to put your money before the market crashes?

Defensive stocks?

Fund managers who have to stay long of the market will typically either shift money into cash or what are called ‘defensive’ stocks in the event of a major bear market. Defensive stocks are companies that are expected to keep most of their value even during a substantial market downturn.

Defensive stocks will maintain better earnings and dividends during periods of economic downturn. They tend to be companies involved in sectors less likely to be affected by cutbacks in consumer spending – e.g. they make stuff people will still buy regardless. Good examples are pharmaceutical companies and utilities, as they provide services that are still considered to be essential. Tobacco firms and drinks manufacturers also seem to hold their value, as consumers who smoke will still prioritise their booze and cigarettes!

Inverse ETFs?

With the growth of the exchange traded fund market (ETFs), several fund managers who now introduced inverse ETFs. These are funds which will move in the exact opposite direction of the index they are tracking. Inverse ETFs are ideal if you want to make money in a bear market, and represent a good alternative to simply moving into cash.

For example, db x-trackers offer an ETF that performs inversely to the S&P 500. Sadly there is not as wide a range of inverse ETFs as bear market ones.

Contracts for Difference?

Contracts for difference or CFDs are higher risk investment products, which need to be managed carefully. CFDs, like inverse ETFs, allow you to short the market. You can open short trades on most major indexes and the shares of larger companies, and make money if they go down in value. Unlike Exchange Traded Funds, there is a wider array of choice in the CFD market.

Before buying a CFD, make sure you understand the risks involved in margin trading, as it is possible to lose more money than you invest initially. Also, it is probably better to only start buying CFDs when a bear market has established itself. Trying to short the S&P 500 during a bull run will just prove an expensive hobby.

The VIX Index?

CFDs can also be used to buy the VIX index. This is an index that is calculated using option prices on the S&P 500 index and is a widely recognised measurement of the level of fear in the market. This is why it is also known as the Fear Index.

The VIX will go up in value if the market’s expectations of volatility in the S&P 500 stocks go up. In November 2008 it established a record high of over 80. When you consider that it is a measure of between 0 and 100, and at the time of writing it was slightly over 9, this shows you just how much panic there was in the market in 2008.

VIX can be traded in the UK with some brokers offering it as a financial spread bet or a Contract for Difference. Some US and Canadian managers also offer ETFs based on the VIX, like iPath, ProShares and VelocityShares.

Commodities?

In a bear market it sometimes pays to invest in commodities. In particular, gold is considered to be a very good store of value when inflation is taking off and markets are going berserk. During the Great Financial crisis, the price of gold rocketed from $700/oz to almost $1900/oz in Q3 2011. Since then it has returned to a more modest level, but any problems with stock markets could see gold on the march again.

Silver can also be a good bet during a bear market. Like gold, it rocketed in 2008-09, from $5-$10 in 2008 to nearly $50 by April 2011. This at a time when stocks were moving in the opposite direction.

Some commodities can perform well regardless of the direction of stock markets. If a stock market crash is followed by an economic downturn, it is best to avoid energy and industrial metals. Softs, like soy beans or pork bellies can still do well if you can time the market correctly, but you really need to understand what is happening within that particular agricultural market.

Hedge funds?

Hedge funds are often a favoured place to put your money before the market crashes or during periods of market turbulence. As funds they have not been performing so well during the current bull cycle. Many hedge funds make their money from exploiting volatility in the market, working the market on the short side, or trading so-called non-correlated assets, markets that are not going to be driven by stock market cycles – a good example are funds that just trade currencies.

Hedge funds are usually considered to be the preserve of very wealth investors, but it is also possible to access some hedge funds if you are a retail investor. BH Macro (LSE: BHMG) for example is a listed investment trust that is managed by UK hedge fund manager Brevan Howard. Another example is Pershing Square, managed by legendary American hedge fund guru Bill Ackman, which listed shares on the Specialist Funds Market on the London Stock Exchange (LSE: PSH) in May 2017.

The Armchair Trader says:

The important thing to bear in mind when the market turns is that it is possible to make money in a bear market, and many fortunes have been made this way. While many investors will simply sell their shares and leave the cash in an account making less than 0.5% per annum, savvy investors take bear markets as an opportunity to make more money, in different ways.

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19th December 2017
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