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Are You Ready For The Next Crash?

Did you know that three decades ago, people around the world were throwing money at the stock market without a care in the world? They believed that nothing could possibly go wrong. Does that ring any bells?

Then the stock market crashed in spectacular fashion on 19th October. The day was called Black Monday.

Clueless

No one still quite knows why and how Black Monday happened. It just did.

It seems that investors from Tokyo in the East to America in the West, and all those punters in between, all panicked at the same time. It was almost as though someone had shouted “fire” in a packed picture house.

There was pandemonium from Wall Street in New York to Threadneedle Street in London to Pedder Street in Hong Kong.

Investors scrambled over each other to sell shares. They couldn’t get rid of them fast enough. The Dow Jones Industrial Index lost a-fifth of its value in double-quick time. It was scary, unless you knew what you were doing.

Robots

The crash has been blamed on automatic trading programmes. That’s where computers make decisions independent of humans about when to buy and sell shares.

So, the moment one computer started to sell, others quickly followed, which set off an almost unstoppable cascading of share prices.

That problem has been fixed. These days stock markets have put in place circuit breakers that prevent them from falling too much, too quickly. They should, at least, stop traders from panic selling.

But automatic trading still exists. They call them quants, these days. It accounts for around a quarter of all trades that take place in the market. That is nearly double the quantity in 1987.

Uncomfortable

But there are uncomfortable similarities between now and the markets in the lead up to Black Monday.

Stock markets at the time were in midst of a bull run. Valuations were looking a little stretched, but nothing that couldn’t be justified. There was also plenty of cash in the system and property prices were rising quickly. People felt rich.

Does any of that sound familiar?

But there is one big difference between then and now.

Pricey

Interest rates today are a lot lower than in 1987. That can make a big difference to valuations.

Back in 1987, the US market was valued at around 20 times profits. So, if US companies had paid out all their profits as dividends, it would be equivalent to a yield of 5%….

….meanwhile, interest rates were at 10%, though they were heading lower. But the difference between the risk-free rate of return and returns from the stock market was wide enough to make some investors think twice.

That is not the case today. Currently, US 10-year Treasury yields are around 2.5%, while earnings yield is 5%. So, the stock market still looks like a better place for our money.

Complacency

But that is no reason to be complacent. It was complacency that caused Black Monday.

A diversified portfolio is still our best insurance against a market crash. We won’t be able to avoid losses totally, if that happens. But building a robust portfolio can help to limit the impact of a market downturn.

So, make sure you have around 15 shares from different sectors in your portfolio. Make sure they are uncorrelated. In other words, ensure that they are as unconnected as possible in terms of geography and business type.

That might seem like a tall order. But really it is not that hard.

I would like to you find those shares from the list of companies that we have already identified as wonderful businesses. All you have to do is click here. That has got to be a good way to prepare for the net crash.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.