What is your plan for a correction, over-correction or crash?

Earnings are suspect, wages, consumer spending and new home sales are problematic, the Fed is talking about raising interest rates and the US market hasn’t seen a 10% correction since 2011 (Yardeni).

With both the Dow and S&P negative for 2015 it’s an appropriate time to ask some questions. Let’s start by taking a look at the Chinese stock market which is being driven primarily by individual investors who have recently discovered how to invest on margin (borrowed money). 

The rapid rise and fall of the Chinese stock market this year is useful example of the powerful effect of human emotions on investing success. As the market peaked in May investors not only piled in but doubled down by borrowing money on margin. This was after a 150% move up when rational investors should have been contemplating taking profits. In less than a month the market dropped 35% as fear took over. 

Back home second quarter earnings are coming in and the results are not what one would expect in the middle of an economic expansion. 187 of the 500 companies in the S&P 500 have reported and earnings are 2.2% less than a year ago (factset). This is before Exxon Mobil and Chevron report at the end of July. 

A correction at this point shouldn’t surprise anyone. Since the market as gone 4 years without one, the chances of the market correcting more than 10% are elevated. Some investors will be facing the first correction of their investing career. What will they do? Will they let fear take over? Will they engage or disengage? Will the robo-advisors survive? What will you do when it arrives?

The single most important question that you need to answer is this: Will you have the cash to buy in when prices drop? A correction (or worse) is an entry point not an exit point. This is counter intuitive to most investors because it goes against their emotions. If prices drop you have to have some buying power to take advantage of it. 

The second question to answer is this- Where can I raise cash now so I’ll have some buying power then? If you are contributing regularly to a company sponsored plan (401k, etc…) your next paycheck will give you buying power. If you are fully invested now consider building up some cash by rebalancing some of the riskier asset classes in your portfolio back to where they were two years ago. 

Once you have a cash stash, consider where you might deploy it when a correction arrives. What asset classes are underweight in your portfolio? Many investors could use more exposure to foreign stocks and bonds. 

This isn’t market timing. It’s prudent, proactive asset management designed to take control of the greed and fear that makes other investors reactive.