What to Do If You Believe A Market Drop Is Coming

Based on the initial reaction in index futures this morning to what looks like a quite worrying PPI print, there is a remarkably resilient nature to the current bull market. It seems that, for now, good news on inflation and therefore on the path of interest rates sparks buying, while what should be bad news in those regards is met with indifference at best. I don’t want to be a party pooper, but that cannot go on forever.

The move up has been predicated on some assumptions about rate cuts and, after two consecutive months of evidence that inflation has stalled at a level above the Fed’s target rate, those cuts are likely to be delayed significantly. Even though the U.S. economy has proved to be stronger in the face of rates at around four or five percent than most people anticipated, stocks at current levels can only be justified if those interest rates are cut back somewhat before any more slowing of growth occurs. That now looks a lot less likely than it did just a few months ago.

Add in the fact that in markets nothing ever moves in a straight line, and a drop, a correction, a consolidation, or whatever you want to call it, is coming. It is a matter of when, not if. So, what should the average investor be doing to prepare?

The conventional answer to that question is “nothing,” for two main reasons.

First and foremost, doing nothing is almost always the best option for long-term investors, particularly those who contribute regularly to their retirement investments by way of a 401k or have a planned dollar cost averaging approach to funding their portfolios. Those things are designed to minimize the impact of the market’s inevitable volatility. Should the market start falling, those who invest that way can console themselves with the thought that they will be buying in at cheaper prices before too long, reducing the fear factor of “knowing” that a downturn is coming.

The second reason is simply timing. As the old traders’ saying goes, the market can stay illogical a lot longer than you can stay solvent. So, while some kind of correction looks inevitable at some point, there is no guarantee that “some point” is coming soon. There are countless examples in the history of the stock market of what Alan Greenspan famously called “irrational exuberance.”

Stocks almost always overshoot the logical endpoint of a move, whether that move is up or down, and that has massive consequences if you are worried that we are at that logical endpoint around here on the current strength. You may believe that a correction is coming, but does it make sense to sell into a market that could defy logic and climb another twenty percent or so in anticipation of a ten percent drop? Of course not.

There is, however, one reason why taking some action now is the right thing to do for most investors. All of the above are perfectly logical reasons to just sit tight and ride out any volatility that may be coming, but most investment decisions are not based on logic; they are based on emotions.

Fear of a big drop is a powerful thing, as is the hubris that leads to people wanting to “do something” in front of a decline in the market so that they can say they did to themselves, their friends, or anyone who will listen. Those emotions, however, can be controlled if you do indeed do something, but something in a calm, restrained way before a drop starts.

This could be like things like adjusting your portfolio to increase or even include exposure to bonds. Until recently, I was one of those who believed that, even for someone like me who is in the last stretch of retirement savings, holding bonds was a waste of money and likely increased, rather than decreased, the risk of my overall portfolio.

Interest rates at or near zero could only prevail for so long, and buying bonds when that was the case offered no yield and an almost certain loss of capital. Now, though, with the Fed Funds rate at 5.5%, bonds once again offer a decent yield and the prospect of some capital appreciation so a good, old-fashioned 60/40 portfolio makes sense.

A case can also be made for dialing down the risk in your holdings. Maybe taking some profit on those AI related or other tech stocks that have done well for you and reinvesting in much more boring sectors like consumer staples, manufacturing, and maybe even utilities.

The main thing, though, is to take small, not particularly consequential actions at a time like this. That way if stocks do head lower, you can calm your fears and tell whoever you want that you saw the drop coming and acted early, but if the current strength continues, you will still be invested in the things that will outperform.

As inevitable as a correction looks from here, there are signs that it isn’t coming any time soon, not least the fact that stocks will open higher this morning as I write this, on a higher than expected read on PPI. That shows a confidence that refuses to yield to things like logic and facts and, in the face of that, investors should be cautious about making any big moves no matter how certain they may feel that the market will turn before too long.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.