Four Ways to Protect Yourself from Another Market Crash

  Jim Gilliland, CFA
  President & CEO, Head of Fixed Income                   

 

Six years ago this month, the venerable, 158-year-old investment banker Lehman Brothers collapsed and the world was plunged into the worst financial crisis since the Great Depression. As the sixth anniversary of the crash approaches, some investors are worried another one could already be around the corner. So just how have capital markets changed since then, and what have we learned?

In some ways, the market has fundamentally changed, not unlike after the Great Depression of the 1930s when a generation became frightened of investing in stock markets. Though currently North American stock markets have been setting record highs as credit markets touched record low yields.

The 2008 crisis prompted the U.S. Federal Reserve to pump massive stimulus dollars into the economy. That move pushed bond yields to their lowest point in 75 years. This forced investors to seek income from “bond-surrogate” investments such as high-dividend-paying stocks, high-yield bonds, levered loans and real estate.

The proliferation of these products and strategies has brought different risks to investors, including liquidity issues, expensive valuations and regulatory changes. Governments have introduced much tougher capital rules on U.S. and international banks to reduce the chance of future bank failures. This has led banks to use far less of their own capital in global markets, which, in turn, has reduced secondary market liquidity for many securities and removed some of the more credit-worthy bank counterparties in these markets.

Here are four lessons from 2008 that investors can apply today:

1. Be skeptical of the next new product or approach to investing. The crisis in 2008 was presaged by a record set of innovations in credit markets. Sub-prime asset-backed securities, collateralized debt obligations and increased leverage magnified what might have been a contained real estate correction to a broader financial collapse. Today, we see many new alternative strategies, asset classes and products, all with their own risks.

2. Plan ahead so you are not forced to sell when market liquidity dries up. The inability to effectively transact in an illiquid market hastened the 2008 crisis. Market participants were forced to sell securities at fire sale prices. Avoid this by owning high-quality investments and use effective diversification with high-quality fixed income investments, mixed with appropriately priced stocks.

3. Be aware of the impact of debt levels. In 2008, high levels of debt or leverage adversely affected markets. We saw this economy-wide as consumers struggled with increased mortgages and consumer debt. Companies also struggled to restructure under tighter credit conditions.

4. Remember that markets will recover. If your financial plan is adequate and you don’t need to sell, don’t panic and avoid selling securities when the outlook seems bleak. This is when successful investors are buying, not selling.

Today, investor surveys show that people are quite skeptical of the market’s increase. Investors seem to be watching for what could come next. In recent years, some things have been labeled the “Next Lehman,” like China’s potential economic slowdown, a bankruptcy of Greece or high U.S. government debt levels. But the U.S. went close to 80 years between the Great Depression and 2008’s crisis. It’s unlikely the next Lehman will occur until the current set of market participants have fully forgotten about the last Lehman.

Still, watch for these warnings signs:

Market valuations: They have increased over the last several years, but in general market levels have been supported by lower interest rates and improved earnings.

Investor mania or failure to appreciate investment risk: Today, many investors are preoccupied with what could go wrong, rather than filled with overconfidence in the markets. However, as we mentioned above, the number of new bond-surrogate-type products can be worrisome.

The 2008 crisis is a reminder to embrace investment strategies that stand the test of time. Investors should heed lessons learned from history to create a portfolio that can withstand tough markets, respect the past and be open to the opportunities of the future.

 

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.  The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.

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